Effective duration
Principles of Finance glossary · Valuation of Bonds & Stocks
Definition
A bond's duration computed by numerical perturbation; required for bonds with embedded options.
Effective duration in plain English
Duration measures how much a bond's price moves when interest rates change — a bond with high duration swings a lot, a low one barely budges. 'Effective' duration figures this out by simple experiment rather than a tidy formula: you nudge interest rates a little up, then a little down, see how the bond's price reacts each way, and measure the sensitivity from those two points (that nudge-and-observe trick is the 'numerical perturbation'). You need this hands-on method for bonds with 'embedded options' — bonds the issuer can pay back early, for instance — because the possibility of early payoff bends the price-vs-rate relationship in ways a plain formula can't capture. It's like measuring how bouncy a trampoline is by actually pressing down and watching, instead of trusting the label.
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