Effective duration measures interest rate sensitivity for bonds with embedded options (callable, putable, mortgage-backed securities). Modified duration assumes cash flows are fixed, but callable bonds have uncertain cash flows — if rates fall, the issuer may call the bond. Effective duration captures this by calculating duration using option-adjusted cash flows. Calculation: Shock yields up/down by small amount (e.g., ±25bp), reprice bond with option model, measure price sensitivity. Example: A 10-year callable bond might have modified duration of 7, but effective duration of 4 if it's likely to be called in 5 years. When to use: Always use effective duration for MBS, callables, putables. Use modified duration only for option-free bonds.