Fixed Income Questions.. following, expected, factors, change, effective

islandgyrl

1*)When compared to modified duration, effective duration
a)is equal to mod. duration for callable bonds but not putable bonds
b)factors in how embedded options will change expected cash flows
c)places less weight on recent changes in bond ratings


2*)Which of the following explains why modified duration should least lieky be used for a bond with a call option. Modified duration assumes that the Cash flows for bonds will
a)change with bonds embedded options
b)not change
c)be affected by convertible bond

Can any one help with answers/explanations?

cchang

Effective duration takes the changes in cash flows due to options exercise into accoutn, but mdified duration doesn't. this gives you the correct answers (for #1 it's (b) and for #2 it's (b)). If the option were unlikely to be exercised (i.e. it's deep out of the money), modified and effective duration would be pretty much the same.