What is in finance, what is effective duration?
Effective duration is the type of measurement used to estimate the amount of return on investment, allowing possible changes to the interest rate related to the investment. Also known as the empirical duration, the basic formula of duration is often used with bonds and similar investments where floating or variable interest rate is paid. Although there are other means of calculation, the return on investment that does not have a fixed interest rate, the effective duration is considered to be the most reliable.
The calculation of efficient duration is particularly important if the investment is likely to issue a part of the return regularly throughout the life of the binding. By defining the duration in terms of time from the last paycheck to the date on which another payment is issued, it is possible to reflect what will happen at the prevailing interest rate in the meantime. Exactly the calculation of this figureculps investor has a good idea of what type of return to expectations for a given period and how this return will affect cash flow.
In most cases, the effective duration is expressed in terms of years. This is because most of the investments that offer a return on interest rates are either worthwhile at the moment of maturity, or every few years of security. When attempting to determine the overall effective duration of investment from the place of purchase to the day when the maturity is achieved, it is sometimes useful to consider any period when the payment is calculated and issued. If no return is expected until the investment has reached maturity, then the whole life is considered to be part of the calculation.
As with any tool used to screen the return on investment, the duration is only as good as the information used for calculations. This reason should be careful attention to the compilation of the data that will be used in the calculation process. Any inaccuracy could cause the projection to be significantly turned off.As an example, if the projection concerning the displacement of the interest rate in the considered period proved to be inaccurate, then the results of the effective duration will not penetrate. For this reason, investors should be aware of any unexpected shifts to interest rates and be ready to recalculate effective duration when these shifts are reflected.