Effective duration estimates investment return with potential interest rate changes. It’s commonly used for bonds and investments with variable interest rates, expressed in years. Accurate data is crucial for reliable projections, and investors should recalculate when interest rate changes occur.
Effective duration is a type of measurement used to estimate the amount of return on an investment, allowing for possible changes in the interest rate that is applied to the investment. Also known as empirical duration, the basic duration formula is often used with bonds and similar investments where a variable or variable interest rate applies. While there are other means of calculating the return on an investment that does not have a fixed interest rate, the effective duration is considered one of the most reliable.
Calculating the effective duration is especially important if the investment is likely to issue a portion of the return periodically throughout the life of the bond. By defining the duration under consideration in terms of the time from the last disbursement to the date the next payment will be issued, it is possible to project what will happen to the prevailing interest rate in the interim. Accurately calculating this figure helps the investor get a good idea of what kind of return to expect for the period and how that return will affect cash flow.
In most cases, an effective duration is expressed in terms of years. This is because most investments that offer a return based on interest rates are paid at maturity or every few years over the life of the collateral. When trying to determine the overall effective life of an investment from the point of purchase to the day maturity is reached, it is sometimes useful to consider each period in which a payment is calculated and issued. When no return is expected until the investment reaches maturity, the entire life of the security is considered as part of the calculation.
As with any tool used to project the return on an investment, the effective duration is only as good as the information used for the calculations. For this reason, special attention should be paid to the compilation of the data to be used in the calculation process. Any inaccuracies could cause the projection to be off significantly. As an example, if the projections regarding interest rate changes during the period considered prove inaccurate, then the effective duration results will not be met. For this reason, investors should be aware of any unanticipated changes to interest rates, and be prepared to recalculate the effective duration when and when those changes become apparent.
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