Answer: decrease.

## Explanation In a rising interest rate environment: 1. **Callable bonds** have negative convexity - as interest rates rise, the probability of the bond being called decreases, making the callable bond behave more like a non-callable bond. 2. **Effective duration** measures the sensitivity of a bond's price to changes in interest rates. 3. When interest rates rise: - The call option becomes less valuable (out-of-the-money) - The callable bond's effective duration increases (becomes more sensitive to interest rate changes) - The non-callable bond's duration remains relatively stable - Therefore, the **difference** in effective duration between callable and non-callable bonds **decreases** 4. Conversely, in a falling interest rate environment, the call option becomes more valuable (in-the-money), causing the callable bond's effective duration to decrease significantly as the probability of being called increases, widening the difference with non-callable bonds. **Key Concept**: Callable bonds exhibit negative convexity - their duration decreases when interest rates fall (due to increased call risk) and increases when interest rates rise (due to decreased call risk). This causes the duration difference with non-callable bonds to narrow in rising rate environments.

Author: LeetQuiz .