Fixed Income【Reading 59】Sample interest, method, 2012, following

Kingpin804

Which of the following approaches in measuring interest rate risk is most accurate when properly performed?

A) Duration approach.

B) Duration/convexity approach.

C) Full Valuation approach.

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The most accurate approach method for measuring interest rate risk is the so-called full valuation approach. Essentially this boils down to the following four steps: (1) begin with the current market yield and price, (2) estimate hypothetical changes in required yields, (3) recompute bond prices using the new required yields, and (4) compare the resulting price changes. Duration and convexity are summary measures and sacrifice some accuracy.

Kingpin804

Which of the following steps is NOT used in the full valuation approach in measuring interest rate risk?

A) Calculate the bond's convexity.

B) Compare resulting price changes.

C) Estimate hypothetical changes in required yields.

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The most straightforward approach method for measuring interest rate risk is the so-called full valuation approach. Essentially this boils down to the following four steps: (1) begin with the current market yield and price, (2) estimate hypothetical changes in required yields, (3) recompute bond prices using the new required yields, and (4) compare the resulting price changes.

Kingpin804

Holding other factors constant, the interest rate risk of a coupon bond is higher when the bond's:

A) current yield is higher.

B) coupon rate is higher.

C) yield to maturity is lower.

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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.

In this case the only determinant that will cause a higher interest rate risk is having a low yield to maturity (initial yield). A higher coupon yield and a higher current yield will cause for lower interest rate risk.

Kingpin804

If interest rates fall, the:

A) value of call option embedded in the callable bond falls.

B) callable bond's price rises faster than that of a noncallable but otherwise identical bond.

C) callable bond's price rises more slowly than that of a noncallable but otherwise identical bond.

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When a callable bond's yield falls to a certain point, when the yields fall the price will increase at a decreasing rate. Compare this to a noncallable bond where, as the yield falls the price rises at an increasing rate.

Kingpin804

In comparing the price volatility of putable bonds to that of option-free bonds, a putable bond will have:

A) less price volatility at low yields.

B) less price volatility at higher yields.

C) more price volatility at higher yields.

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The only true statement is that putable bonds will have less price volatility at higher yields. At higher yields the put becomes more valuable and reduces the decline in price of the putable bond relative to the option-free bond. On the other hand, when yields are low, the put option has little or no value and the putable bond will behave much like an option-free bond. Therefore at low yields a putable bond will not have more price volatility nor will it have less price volatility than a similar option-free bond.

Kingpin804

A $1,000 face, 10-year, 8.00% semi-annual coupon, option-free bond is issued at par (market rates are thus 8.00%). Given that the bond price decreased 10.03% when market rates increased 150 basis points (bp), which of the following statements is CORRECT? If market yields:

A) decrease by 150bp, the bond's price will decrease by more than 10.03%.

B) decrease by 150bp, the bond's price will increase by more than 10.03%.

C) decrease by 150bp, the bond's price will increase by 10.03%.

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All other choices are false because of positive convexity - bond prices rise faster than they fall. Positive convexity applies to both dollar and percentage price changes. For any given absolute change in yield, the increase in price will be more than the decrease in price for a fixed-coupon, noncallable bond. As yields increase, bond prices fall, and the price curve gets flatter, and changes in yield have a smaller effect on bond prices. As yields decrease, bond prices rise, and the price curve gets steeper, and changes in yield have a larger effect on bond prices. Here, for an absolute 150bp change, the price increase would be more than the price decrease. For a 100bp increase, the price decrease would be less than that for a 150bp increase.

Kingpin804

Which of the following bonds is likely to exhibit the greatest volatility due to interest rate changes? A bond with a:

A) low coupon and a long maturity.

B) high coupon and a long maturity.

C) low coupon and a short maturity.

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There are three features that determine the magnitude of the bond price volatility:
(1) The lower the coupon, the greater the bond price volatility.
(2) The longer the term to maturity, the greater the price volatility.
(3) The lower the initial yield, the greater the price volatility.
So the bond with a low coupon and long maturity will have the greatest price volatility.

Kingpin804

Which of the following bonds experience the greatest precentage price change when the market interest rates rise?

A) A high coupon, long maturity bond.

B) A low coupon, short maturity bond.

C) A low coupon, long maturity bond.

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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.

According to these three features the greatest price change will come from the bond with a low coupon and long maturity.

Kingpin804

With market interest rates at 6%, an analyst observes a 5-year, 5% coupon, $1,000 par value callable bond selling for $950. At the same time the analyst observes a non-callable bond, identical in all other respects to the callable bond, selling for $980. The analyst should estimate that the value of the call option on the callable bond is closest to:

A) $50.

B) $30.

C) $20.

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The difference in price between the two bonds is the value of the option: $980 − $950 = $30.

Kingpin804

An investor gathered the following information about two 7% annual-pay, option-free bonds:

• Bond R has 4 years to maturity and is priced to yield 6%
• Bond S has 7 years to maturity and is priced to yield 6%
• Both bonds have a par value of $1,000.

Given a 50 basis point parallel upward shift in interest rates, what is the value of the two-bond portfolio?

A) $2,044.

B) $2,030.

C) $2,086.

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Given the shift in interest rates, Bond R has a new value of $1,017 (N = 4; PMT = 70; FV = 1,000; I/Y = 6.50%; CPT → PV = 1,017). Bond S’s new value is $1,027 (N = 7; PMT = 70; FV = 1,000; I/Y = 6.50%; CPT → PV = 1,027). After the increase in interest rates, the new value of the two-bond portfolio is $2,044 (1,017 + 1,027).