Answer: Effective duration

## Explanation **Effective duration** is the most appropriate duration measure for a callable bond because: 1. **Accounts for embedded options**: Effective duration measures the sensitivity of a bond's price to changes in interest rates while considering the impact of embedded options (like call features). 2. **Considers option-adjusted cash flows**: Unlike modified duration or Macaulay duration, effective duration accounts for how cash flows may change when interest rates change due to the call option being exercised. 3. **Why the other options are incorrect**: - **Modified duration**: Assumes cash flows are fixed and doesn't account for embedded options. It's appropriate for option-free bonds. - **Macaulay duration**: Measures the weighted average time to receive cash flows, but also doesn't account for embedded options. 4. **Key concept**: For bonds with embedded options, effective duration provides a more accurate measure of interest rate risk because it reflects how the bond's cash flows may change with interest rate movements. **Example**: When interest rates fall, a callable bond is more likely to be called by the issuer, which changes the bond's cash flow pattern and duration. Effective duration captures this dynamic relationship.

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