Q6. Brown is now considering the effects of convexity in isolation. Of all the bonds in Tables 1 and 2, Brown wonders which would be the most likely to have the best convexity properties with respect to investing. Which of the following bonds has the most desirable convexity properties?

A)   IF.

B)   FRN.

C)   Fixed coupon ABC bond.

Q7. Brown now begins analyzing the FRN in Table 2. Specifically, she would like to price the FRN immediately following a coupon payment. Which of the following is the closest to Brown's answer?

A)   107.18.

B)   97.56.

C)   100.00.

Q8. Convexity is more important when rates are:

A)   high.

B)   unstable.

C)   low.

Q6. Brown is now considering the effects of convexity in isolation. Of all the bonds in Tables 1 and 2, Brown wonders which would be the most likely to have the best convexity properties with respect to investing. Which of the following bonds has the most desirable convexity properties? fficeffice" />

A)   IF.

B)   FRN.

C)   Fixed coupon ABC bond.

Correct answer is A)

The IF will have the highest convexity of all the bonds. The higher the convexity the better for the investor.

Q7. Brown now begins analyzing the FRN in Table 2. Specifically, she would like to price the FRN immediately following a coupon payment. Which of the following is the closest to Brown's answer?

A)   107.18.

B)   97.56.

C)   100.00.

Correct answer is C)

At a coupon reset date, the floating rate bond is always equal to its par value since the coupon yield is the same as the discount rate used to price the bond. So the two rates cancel each other.

Q8. Convexity is more important when rates are:

A)   high.

B)   unstable.

C)   low.

Correct answer is B)

Since interest rates and the price of bonds are inversely related, unstable interest rates will lead to larger price fluctuations in bonds. The larger the change in the price of a bond the more error will be introduced in determining the new price of the bond if only duration is used because duration assumes the price yield relationship is linear when in fact it is a curved convex line. If duration alone is used to price the bond, the curvature of the line magnifies the error introduced by yield changes, and makes the convexity adjustment even more important.