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Answer: The bond's future cash flows are uncertain due to the embedded option.
Effective duration is the most appropriate measure for bonds with embedded options because their future cash flows are uncertain. This uncertainty arises from the issuer's ability to call the bond, which depends on future interest rates. Unlike yield duration measures (e.g., modified or Macaulay duration), effective duration accounts for the variability in cash flows due to the embedded option. Option B is incorrect because callable bonds do not have a well-defined internal rate of return. Option C is incorrect because effective duration measures sensitivity to changes in the benchmark yield curve, not credit spreads, which are assessed separately.
Author: LeetQuiz Editorial Team
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For a bond with an embedded option, why is effective duration the most appropriate measure of interest rate risk?
A
The bond's future cash flows are uncertain due to the embedded option.
B
The bond's internal rate of return is clearly defined.
C
The bond's pricing is highly sensitive to changes in credit spreads.
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