medium · Principles of Finance valuation
What is the primary reason that professional bond traders use 'Effective Duration' instead of 'Modified Duration' when valuing Mortgage-Backed Securities (MBS)?
- Modified duration assumes fixed cash flows, but MBS cash flows change as interest rates impact homeowner prepayment behavior.
- Modified duration is mathematically invalid for any bond that pays interest more than once per year, as with MBS.
- Effective duration accounts for the credit risk embedded in the underlying mortgage pool, which modified duration ignores.
- Effective duration is always mathematically higher than modified duration for any security, giving a more conservative risk estimate.
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