Chartered Financial Analyst (CFA) Practice Exam Level 2

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What happens to the duration of a bond when it has an embedded option?

The duration increases.
The duration decreases.
The duration remains unchanged.
The duration becomes unpredictable.

The correct answer is: The duration decreases.

When a bond has an embedded option, its duration is affected because the option alters the cash flow characteristics of the bond. For instance, if a bond has a call option, the bondholder has the right to redeem the bond before maturity. This introduces additional uncertainty in the timing of cash flows, as the issuer may choose to call the bond if interest rates fall. As a result, the expected cash flows will be more sensitive to interest rate changes, reducing the bond's effective duration. Duration measures the sensitivity of a bond's price to changes in interest rates, and when an embedded option is present, especially one that allows for early redemption, this effectively shortens the average time until cash flows are received. Hence, the bond's duration typically decreases in the presence of an embedded option. Overall, the duration reflects the bond holder's exposure to interest rate risk, and the option introduces variability that lessens this risk, resulting in a decreased duration.