A working example of effective duration calculation. Earlier we had reviewed the calculation process for Macaulay and Modified Duration. In this post we will focus on the steps for calculating Effective Duration.
Effective Duration
Effective Duration is calculated using the following formula:
Where,
Delta_i= change in yield = 1%
P0= Initial Price
P+= Price if yields increase by Delta_i
P–= Price if yields decline by Delta_i
We are calculating the effective duration of the sample instrument on the issue date. Therefore P0 is equal to the price calculated above, i.e. 98.1666.
To calculate P+ we use the same methodology for calculating the initial price but assume that the YTM has increased by 1% to 13%.