Effective Duration measures a bond's price sensitivity to interest rate changes when the bond has embedded options (callable/putable bonds) — it accounts for the change in cash flows as rates change.
Standard Modified Duration assumes fixed cash flows — but callable bonds (issuer can repay early) and putable bonds (investor can demand early repayment) have cash flows that change depending on interest rates. Effective Duration uses actual price changes from small rate shifts (±x basis points) to empirically measure sensitivity: Effective Duration = −(P+ − P−) ÷ (2 × P₀ × Δy). For bonds without embedded options, Effective Duration ≈ Modified Duration. For callable bonds in a falling rate environment, Effective Duration is lower (the call option limits price upside).
Modified Duration works for plain vanilla bonds. Effective Duration is the version that handles bonds with 'fine print' — like callable bonds (company can pay you back early if rates fall). A callable bond won't rise as much as a regular bond when rates fall, because the company will just call it back. Effective Duration captures this realistic price sensitivity rather than the theoretical modified duration.
Calculate bond price at Yield − Δy (P+) and Yield + Δy (P−).
Effective Duration = (P+ − P−) ÷ (2 × P₀ × Δy).
For callable bonds: Effective Duration < Modified Duration.
Relevant for analysing callable corporate bonds, mortgage-backed securities.
Most Indian G-Sec and corporate bonds are non-callable — Modified = Effective Duration.