mouse123

How does the price-yield relationship for a putable bond compare to the same relationship for an option-free bond? The price-yield relationship is:

A) more convex at some yields for the putable bond than for the option-free bond.

B) the same for both bond types.

C) more convex for a putable bond than for an option-free bond.

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Since the holder of a putable has an incentive to exercise his put option if yields are high and the bond price is depressed, this puts a lower limit on the price of the bond when interest rates are high. The lower limit introduces a higher convexity of the putable bond compared to an option-free bond when yields are high.

mouse123

Jayce Arnold, a CFA candidate, is studying how the market yield environment affects bond prices. She considers a $1,000 face value, option-free bond issued at par. Which of the following statements about the bond’s dollar price behavior is most likely accurate when yields rise and fall by 200 basis points, respectively? Price will:

A) increase by $149, price will decrease by $124.

B) decrease by $149, price will increase by $124.

C) decrease by $124, price will increase by $149.

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As yields increase, bond prices fall, the price curve gets flatter, and changes in yield have a smaller effect on bond prices. As yields decrease, bond prices rise, the price curve gets steeper, and changes in yield have a larger effect on bond prices. Thus, the price increase when interest rates decline must be greater than the price decrease when interest rates rise (for the same basis point change). Remember that this applies to percentage changes as well.

mouse123

Which of the following bonds may have negative convexity?

A) Mortgage backed securities.

B) Callable bonds.

C) Both of these choices are correct.

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Negative convexity is the idea that as interest rates decrease they get to a certain point where the value of certain bonds (bonds with negative convexity) will start to increase in value at a decreasing rate.
Interest rate risk is the risk of having to reinvest at rates that are lower than what an investor is currently receiving.
Mortgage backed securities (MBS) may have negative convexity because when interest rates fall mortgage owners will refinance for lower rates, thus prepaying the outstanding principle and increasing the interest rate risk that investors of MBS may incur.
Callable bonds are similar to MBS because of the possibility that the principle is being returned to the investor sooner than expected if the bond is called causing a higher level of interest rate risk.

mouse123

Consider two bonds, A and B. Both bonds are presently selling at par. Each pays interest of $120 annually. Bond A will mature in 5 years while bond B will mature in 6 years. If the yields to maturity on the two bonds change from 12% to 10%, both bonds will:

A) increase in value, but bond A will increase more than bond B.

B) increase in value, but bond B will increase more than bond A.

C) decrease in value, but bond B will decrease more than bond A.

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There are three features that determine the magnitude of the bond price volatility:

• The lower the coupon, the greater the bond price volatility.
• The longer the term to maturity, the greater the price volatility.
• The lower the initial yield, the greater the price volatility.

Since both of these bonds are the same with the exception of the term to maturity, the bond with the longer term to maturity will have a greater price volatility.  Since bond value has an inverse relationship with interest rates, when interest rates decrease bond value increases.

mouse123

Positive convexity means that:

A) as interest rates change, bond prices will increase at an increasing rate and decrease at a decreasing rate.

B) the graph of a callable bond flattens out as the market value approaches the call price.

C) the price of a fixed-coupon bond is inversely related to changes in interest rates.

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Positive convexity refers to the principle that for a given change in market yields, bond price sensitivity is lowest when market yields are high and highest when market yields are low.
Although the statements that begin, the graph of a callable bond . . . and the price of a fixed-coupon bond . . . are true, they are not the best choices to describe positive convexity.

mouse123

Non-callable bond prices go up faster than they go down. This is referred to as:

A) positive convexity.

B) negative convexity.

C) inverse features.

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When bond prices go up faster than they go down, it is called positive convexity.

mouse123

Negative convexity for a callable bond is most likely to be important when the:

A) price of the bond approaches the call price.

B) bond is first issued.

C) market interest rate rises above the bond's coupon rate.

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Negative convexity illustrates how the relationship between the price of a bond and market yields changes as the bond price rises and approaches the call price. The convex curve that we generally see for non-callable bonds bends backward to become concave (i.e., exhibit negative convexity) as the bond approaches the call price.

mouse123

Assume that the current price of a bond is 102.50. If interest rates increase by 0.5% the value of the bond decreases to 100 and if interest rates decrease by 0.5% the price of the bond increases to 105.5. What is the effective duration of the bond?

A) 5.37.

B) 5.50.

C) 5.48.

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The duration is computed as follows:

Duration =	105.50 − 100	= 5.37
	2 × 102.50 × 0.005

mouse123

The price of a bond is equal to $101.76 if the term structure of interest rates is flat at 5%. The following bond prices are given for up and down shifts of the term structure of interest rates. Using the following information what is the effective duration of the bond?

Bond price: $98.46 if term structure of interest rates is flat at 6%
Bond price: $105.56 if term structure of interest rates is flat at 4%

A) 1.56.

B) 3.49.

C) 1.74.

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The effective duration is computed as follows:

Effective duration =	105.56 − 98.46	= 3.49
	2 × 101.76 × 0.01

mouse123

An international bond investor has gathered the following information on a 10-year, annual-pay U.S. corporate bond:

• Currently trading at par value
• Annual coupon of 10%
• Estimated price if rates increase 50 basis points is 96.99%
• Estimated price is rates decrease 50 basis points is 103.14%

The bond’s duration is closest to:

A) 3.14.

B) 6.15.

C) 6.58.

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Duration is a measure of a bond’s sensitivity to changes in interest rates.
Duration = (V- − V+) / [2V0(change in required yield)] where:
V- = estimated price if yield decreases by a given amount
V+ = estimated price if yield increases by a given amount
V0 = initial observed bond price
Thus, duration = (103.14 − 96.99) / (2 × 100 × 0.005) = 6.15. Remember that the change in interest rates must be in decimal form.