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

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

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

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

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

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

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

A) concave for the callable bond and convex for an option-free bond.

B) concave for low yields for the callable bond and always convex for the option-free bond.

C) the same for both bond types.

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Since the issuer of a callable bond has an incentive to call the bond when interest rates are very low in order to get cheaper financing, this puts an upper limit on the bond price for low interest rates and thus introduces the concave relationship between yields and prices.

mouse123

Can a fixed income security have a negative convexity?

A) Only when the price/yield curve is linear.

B) No.

C) Yes.

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Yes, fixed income securities can have a negative security. The only type of fixed income security with a negative convexity will be callable bonds.  

mouse123

If a put feature expires on a bond so that it becomes option-free, then the curve depicting the price and yield relationship of the bond will become:

A) less convex.

B) more convex.

C) inversely convex.

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When the option expires, the prices at the lower end of the curve will become lower. This will make the curve less convex.

mouse123

Positive convexity in bond prices implies all but which of the following statements?

A) As yields increase, changes in yield have a smaller effect on bond prices.

B) Bond prices approach a ceiling as interest rates fall.

C) The price volatility of non-callable bonds is inversely related to the level of market yields.

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The convexity of bond prices means that bond prices as a function of interest rates approach a floor as interest rates rise.