andytrader

The distinction between modified convexity and effective convexity is that:

A) effective convexity accounts for changes in cash flows due to embedded options, while modified convexity does not.

B) different dealers may calculate modified convexity differently, but there is only one formula for effective convexity.

C) modified convexity becomes less accurate as the change in yield increases, but effective convexity corrects for this.

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Effective convexity is the appropriate measure to use for bonds with embedded options because it takes into account the effect of the embedded options on the bond’s cash flows.

andytrader

Which of the following statements is most accurate concerning the differences between modified convexity and effective convexity?

A) Modified convexity takes into account changes in cash flows due to embedded options, while effective convexity does not.

B) For an option-free bond, modified convexity is slightly greater than effective convexity.

C) Effective convexity is most appropriate for bonds with embedded options.

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Effective convexity is most appropriate for bonds with embedded options because it takes into account changes in cash flows due to changes in yield, while modified convexity does not. For an option-free bond, modified convexity and effective convexity should be very nearly equal.

andytrader

The price value of a basis point (PVBP) for a 7-year, 10% semiannual pay bond with a par value of $1,000 and yield of 6% is closest to:

A) $0.92.

B) $0.28.

C) $0.64.

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PVBP = initial price – price if yield changed by 1 bps.

Initial price:	Price with change:
FV = 1000	FV = 1000
PMT = 50	PMT = 50
N = 14	N = 14
I/Y = 3%	I/Y = 3.005
CPT PV = 1225.92	CPT PV = 1225.28

PVBP = 1,225.92 – 1,225.28 = 0.64
PVBP is always the absolute value.

clearlycanadian

The price value of a basis point (PVBP) of a bond is $0.75. If the yield on the bond goes up by 1 bps, the price of the bond will:

A) increase by $0.75.

B) decline by $0.75.

C) increase or decrease by $0.75.

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Inverse relationships exist between price and yields on bonds. The larger the PVBP, the more volatile the bond’s price.

clearlycanadian

In addition to effective duration, analysts often use measures such as Value–at–Risk (VaR) to estimate the price sensitivity of bonds to changes in interest rates because these measures also incorporate the effects of:

A) time to maturity.

B) embedded options.

C) yield volatility.

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The volatility of a bond’s yield should be considered along with the bond’s effective duration when estimating its price sensitivity to interest rates. Measures of price risk such as VaR account for yield volatility. Effective duration includes the effects of time to maturity and embedded options.