Chartered Financial Analyst (CFA) Practice Exam Level 2

If effective duration is less than maturity, which type of bond is this typically true for?

1. Callable Bonds

2. Putable Bonds

3. Zero Coupon Bonds

4. Floating Rate Bonds

The correct answer is: Callable Bonds

When assessing the relationship between effective duration and maturity, it's particularly pertinent to examine callable bonds. Effective duration measures a bond's sensitivity to changes in interest rates, taking into account the potential impact of embedded options such as call features. Callable bonds often exhibit effective durations that are less than their stated maturities due to the likelihood that the issuer may call the bond before it reaches maturity. When interest rates decline, issuers are more likely to call these bonds, which eliminates the bondholder's exposure to interest rate risk beyond the call date. As a result, the effective duration reflects this reduced sensitivity to interest rate shifts. In contrast, other types of bonds such as putable bonds, zero coupon bonds, or floating rate bonds typically behave differently with respect to their effective duration relative to their maturities. Putable bonds may have longer effective durations because the put option can extend the bond's life, zero coupon bonds have no intermediate cash flows but will mature at a certain date, and floating rate bonds tend to maintain their value through interest resets, which affects their duration characteristics. Thus, when effective duration is less than maturity, it is indeed a commonly observed trait in callable bonds due to the embedded option that allows for early redemption by the issuer.