LOS e, (Part 2): Explain why effective duration is the most appropriate measure of interest rate risk for bonds with embedded options.

Q1. Which of the following explains why modified duration should least likely be used for bonds with call options? Modified duration assumes that the cash flows on the bond will:

A)   not change.

B)   change with the bond's embedded options.

C)   be affected by a convertible bond.

Q2. Why should effective duration, rather than modified duration, be used when bonds contain embedded options?

A)   Modified duration considers expected changes in cash flows.

B)   Effective duration considers expected changes in cash flows.

C)   Either could be used if the bond has embedded options.

Q3. Effective duration is more appropriate than modified duration as a measure of a bond's price sensitivity to yield changes when:

A)   the bond has a low coupon rate and a long maturity.

B)   yield curve changes are not parallel.

C)   the bond contains embedded options.

LOS e, (Part 2): Explain why effective duration is the most appropriate measure of interest rate risk for bonds with embedded options.fficeffice" />

Q1. Which of the following explains why modified duration should least likely be used for bonds with call options? Modified duration assumes that the cash flows on the bond will:

A)   not change.

B)   change with the bond's embedded options.

C)   be affected by a convertible bond.

Correct answer is A)

Modified duration assumes that the cash flows on the bond will not change (i.e., that we are dealing with non-callable bonds). This greatly differs from effective duration, which considers expected changes in cash flows that may occur for bonds with embedded options.

Q2. Why should effective duration, rather than modified duration, be used when bonds contain embedded options?

A)   Modified duration considers expected changes in cash flows.

B)   Effective duration considers expected changes in cash flows.

C)   Either could be used if the bond has embedded options.

Correct answer is B)        

Modified duration assumes that the cash flows on the bond will not change (i.e., that we are dealing with non-callable bonds). This greatly differs from effective duration, which considers expected changes in cash flows that may occur for bonds with embedded options.

Q3. Effective duration is more appropriate than modified duration as a measure of a bond's price sensitivity to yield changes when:

A)   the bond has a low coupon rate and a long maturity.

B)   yield curve changes are not parallel.

C)   the bond contains embedded options.

Correct answer is C)

Effective duration takes into consideration embedded options in the bond. Modified duration does not consider the effect of embedded options. For option-free bonds, modified duration will be similar to effective duration. Both duration measures are based on the value impact of a parallel shift in a flat yield curve.

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effective

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