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The effective duration is a discrete approximation to this latter, ... with US-style 15- or 30-year fixed-rate mortgages as collateral are examples of callable bonds.
The specifics vary from bond to bond, but callable bonds always have one thing in common — the issuer can pay off the bond early. As an investor, there are potential benefits and drawbacks to ...
A callable bond (also called redeemable bond) is a type of bond (debt security) that allows the issuer of the bond to retain the privilege of redeeming the bond at some point before the bond reaches its date of maturity. [1]
The more curved the price function of the bond is, the more inaccurate duration is as a measure of the interest rate sensitivity. [2] Convexity is a measure of the curvature or 2nd derivative of how the price of a bond varies with interest rate, i.e. how the duration of a bond changes as the interest rate changes. [3]
Types of bonds more likely to be affected by reinvestment risk: Callable bonds, short-term bonds, zero-coupon bonds, mortgage-backed securities and asset-backed securities. 4. Liquidity risk
Bonds of this type include: Callable bond: allows the issuer to buy back the bond at a predetermined price at a certain time in future. The holder of such a bond has, in effect, sold a call option to the issuer. Callable bonds cannot be called for the first few years of their life. This period is known as the lock out period.
There are several types of options that can be embedded into a bond; common types of bonds with embedded options include callable bond, puttable bond, convertible bond, extendible bond, exchangeable bond, and capped floating rate note. A bond may have several options embedded if they are not mutually exclusive.
For a bond with an embedded option, the standard yield to maturity based calculations of duration and convexity do not consider how changes in interest rates will alter the cash flows due to option exercise. To address this, effective duration and -convexity are introduced.