What would be a better measure than modified duration?

What will be an ideal response?

Although modified duration may be inappropriate as a measure of a bond's price sensitivity to interest rate changes, there is a duration measure that is more appropriate for bonds with embedded options. Because duration measures price responsiveness to changes in interest rates, the duration for a bond with an embedded option can be estimated by letting interest rates change by a small number of basis points above and below the prevailing yield, and seeing how the prices change.

In general, the duration for any bond can be approximated as follows:

duration = .

where P_ = price if yield is decreased by x basis points, P+ = price if yield is increased by x basis points, P0 = initial price (per $100 of par value), and Δ y (or dy) = change in rate used to calculate price (x basis points in decimal form).

We can show how the application of this formula to an option-free bond gives the modified duration because the cash flows do not change when yields change. When the approximate duration formula is applied to a bond with an embedded option, the new prices at the higher and lower yield levels should reflect the value from the valuation model. Duration calculated in this way is called effective duration or option-adjusted duration.