Bonds: Simplified
Modified vs effective duration
Modified duration assumes the bond's cash flows stay fixed when yield changes. That works best for simple non-optioned bonds and small yield moves. Effective duration is designed for instruments where the cash flow path can change, such as callable bonds or mortgage-backed securities.
The core formula
Effective duration compares the price after a rate decrease with the price after a rate increase, then scales the result by the base price and shock size.
Why MBS needs it
MBS cash flows are tied to borrower prepayments. When rates fall, prepayments can accelerate and principal returns sooner. When rates rise, prepayments can slow and the security can extend. Effective duration captures some of that behavior by recalculating under shocked scenarios rather than treating cash flows as static.
How Bonds: Simplified uses the idea
The app presents duration beside scenario outputs, prepayment speed, WAL, and rate shock tables. That helps connect the summary number to the projected cash flow behavior behind it. For related context, read MBS prepayment speed, PSA vs CPR, and Treasury spreads.