Effective duration is a type of measurement that is used to estimate the amount of return on an investment, allowing for the possible changes in the rate of interest that applies to the investment. Also known as an empirical duration, the basic duration formula is often used with bonds and similar investments where a floating or variable rate of interest applies. While there are other means of calculation the return on an investment that does not have a fixed interest rate, the effective duration is considered to be among the most reliable.
Calculating the effective duration is especially important if the investment is likely to issue a portion of the return periodically throughout the life of the bond. By defining the duration under consideration in terms of the time from the last disbursement to the date that the next payment will be issued, it is possible to project what will happen with the prevailing interest rate in the interim. Accurately calculating this figure helps the investor to have a good idea of what type of return to expect for the period, and how that return will affect cash flow.
In most cases, an effective duration is expressed in terms of years. This is because most investments that offer a return based on interest rates either pay off at the point of maturity, or every few years during the life of the security. When attempting to determine the overall effective duration of an investment from the point of purchase to the day that maturity is reached, it is sometimes helpful to consider each period where a payment is calculated and issued. When no return is anticipated until the investment reaches maturity, then the entire life of the security is considered as part of the calculation.
As with any tool used to project the return on an investment, the effective duration is only as good as the information used for the calculations. For this reason, careful attention should be taken to compiling the data that will be used in the calculation process. Any inaccuracy could cause the projection to be off significantly. As an example, if the projections regarding shifts in the interest rate over the period considered prove to be inaccurate, then the results of the effective duration will not come to pass. For this reason, investors should be aware of any unanticipated shifts to interest rates, and be prepared to recalculate the effective duration when and as those shifts become apparent.