honeycfa

Joshua Reynaldo is a fixed income portfolio manager for Golden Apple Capital Management. The portfolio is valued at $900 million, of which $840 million is currently invested. Fiona Campbell, the firm’s strategist, is becoming concerned about the possibility of an increase in interest rates. Reynaldo agrees, and this makes him nervous because the effective duration of his current portfolio investments is 10.315. However, his portfolio is presented to clients as a long-term fund, so there are limits to how short he can make the duration of the portfolio and still stay within the investment policy guidelines.

Reynaldo needs to invest the $60 million cash currently in the portfolio, and wants to do it in a way that will minimize the portfolio’s downside risk in a rising rate environment. He considers two different bonds. Both trade at their $1,000 par value and make coupon payments semiannually.

The first bond is a 12-year issue of Yorkville Technologies. Reynaldo likes the bond because of its attractive 5.9% coupon. He is concerned, however, because Yorkville is only rated Baa and Campbell is expecting a deterioration in credit quality as part of her economic outlook.

The second bond is also a 12-year maturity, but issued by Mountain States Electric & Gas, an Aaa utility. The 5.2% yield is not as attractive as the lower quality issue, but the Mountain States bond would represent a safe haven if credit spreads begin to widen, as both he and Campbell expect. Reynaldo’s only concern about the Mountain States bond is that it is callable any time at 102.

Discussing these possibilities with Campbell, Reynaldo tells her, “I ran my calculations assuming rates rise or fall by 50 basis points, and found that the effective convexity of the Mountain States bond is ten times the effective convexity of the Yorkville bond.” Campbell adds, “But the signs are opposite – the Mountain States bond has negative convexity and the Yorkville bond has positive convexity.” 

Reynaldo continues, “I haven’t done a full valuation yet, but using my figures for duration and assuming convexity is 46, it looks like a 100 basis point rise in rates would cause the price of the Yorkville bond to fall by 6.73%.” Campbell, looking over his shoulder at his calculations, adds, “The dollar value of an 01 for the Yorkville bond is only 0.063, though.”

Reynaldo decides to invest in the Yorkville bond.

Which statement about how duration tends to predict price changes for large swings in yield is most accurate? Duration:

A) overestimates the increase in price for increases in yield.

B) overestimates the increase in price for decreases in yield.

C) underestimates the increase in price for decreases in yield.

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For large swings in yield, duration tends to underestimate the increase in price when yield decreases and overestimate the decrease in price when yield increases. This is because duration is a linear estimate and does not account for the curvature in the price/yield relationship.

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Using a 50 basis point change in interest rates, what is the difference in effective duration between the Mountain States bond and the Yorkville bond? The effective duration of the:

A) Mountain States bond is 0.34 lower than the effective duration of the Yorkville bond.

B) Yorkville bond is 2.21 higher than the effective duration of the Mountain States bond.

C) Mountain States bond is 0.34 higher than the effective duration of the Yorkville bond.

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In order to calculate effective duration, we first need to know the bond price if interest rates rise or fall by 50 basis points.

For the Yorkville bond:

N = 24; PMT = (0.059 coupon × $1,000 par value / 2 payments per year =) 29.50; FV = 1,000

If rates rise by 50 basis points, I = ((5.9% + 0.50 =) 6.4% / 2 payments per year =) 3.2%; PV = -958.56.
Since the bond has a par value of $1,000, the estimated price will be (958.56 / 1,000 × 100 =) 95.86.

If rates fall by 50 basis points, I = ((5.9% ? 0.50 =) 5.4% / 2 payments per year = ) 2.7%; PV = -1043.74.
Since the bond has a par value of $1,000, the estimated price will be (1043.74 / 1,000 × 100 =) 104.37.

Now that we have the prices, we can use the formula for effective duration (ED):

ED = (104.37 – 95.86) / (2 × 100 × 0.005)
ED = 8.51 / 1
ED = 8.51

For the Mountain States bond:

N = 24, PMT = (0.052 coupon × $1,000 par value / 2 payments per year =) 26.00, FV = 1,000

If rates rise by 50 basis points, I = ((5.2% + 0.50 =) 5.7% / 2 payments per year =) 2.85%; PV = -956.97.
Since the bond has a par value of $1,000, the estimated price will be (956.97 / 1,000 × 100 =) 95.70.

If rates fall by 50 basis points, I = ((5.2% ? 0.50 =) 4.7% / 2 payments per year =) 2.35%; PV = -1045.46.
Since the bond has a par value of $1,000, the estimated price will be (1045.46 / 1,000 × 100 =) 104.55
However, since the bond is callable at 102, the price will be 102, not 104.55.

ED = (102 – 95.70) / (2 × 100 × 0.005)
ED = 6.30 / 1
ED = 6.30

The ED of the Yorkville bond is (8.51 – 6.30 =) 2.21 higher than the ED of the Mountain States bond.

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If Reynaldo must invest his $60 million cash in either the Yorkville bond or the Mountain States bond, or some combination of the two, what is the lowest value he can achieve for the effective duration of the total portfolio?

A) 10.046.

B) 10.194.

C) 9.624.

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If he purchases the Yorkville bond:

Portfolio duration = (w₁ × ED₁) + (w₂ × ED₂)
Portfolio duration = ((840 / 900) × 10.315) + ((60 / 900) × 8.51)
Portfolio duration = (0.933 × 10.315) + (0.067 × 8.51)
Portfolio duration = 9.624 + 0.570
Portfolio duration = 10.194

If he purchases the Mountain States bond:

Portfolio duration = (w₁ × ED₁) + (w₂ × ED₂)
Portfolio duration = ((840 / 900) × 10.315) + ((60 / 900) × 6.30)
Portfolio duration = (0.933 × 10.315) + (0.067 × 6.30)
Portfolio duration = 9.624 + 0.422
Portfolio duration = 10.046

Note, however, that we did not need to calculate the duration of the portfolio if he purchases the Yorkville bond. Since we know that the Mountain States bond has lower effective duration than the Yorkville bond, we know that the lowest effective duration for the total portfolio would be achieved by investing all $60 million in the Mountain States bond.

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Regarding the statements made by Reynaldo and Campbell about the expected price change in the Yorkville bond:

A) both are incorrect.

B) both are correct.

C) only one is correct.

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For the Yorkville bond:

Percentage price change = (-8.51 × 0.010 × 100) + (46.0 × 0.010² × 100)
Percentage price change = -8.51 + 0.46
Percentage price change = -8.05

Reynaldo’s statement is incorrect.

To calculate the dollar value of an 01 we need to know the price of the bond if interest rates rise (or fall) by 1 basis point:

N = 24; PMT = (0.059 coupon × $1,000 par value / 2 payments per year =) 29.50; FV = 1,000

If rates rise by 1 basis point, I = ((5.90 + 0.01 =) 5.91% / 2 payments per year =) 2.955%; PV = -999.149, for a price of 99.915.

PVBP = 100 – 99.915 = 0.085

Campbell’s statement is also incorrect.

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Reynaldo and Apple are training a new analyst, Norah Spears. They ask Spears what she knows about duration and convexity. Spears replies with four statements:

Statement 1:	Modified duration is a better measure than effective duration for bonds with embedded options.
Statement 2:	The convexity adjustment corrects for the error embedded in the duration.
Statement 3:	Modified duration ignores the negative convexity of a callable bond.
Statement 4:	Convexity of option-free bonds is always added to duration to modify the errors in calculating price volatility.

Which of the following regarding Spears’ statements is most accurate?

A) Spears is correct with respect to Statement 2, but incorrect with respect to Statement 4.

B) Spears is correct with respect to all four statements.

C) Spears is correct with respect to Statement 3, but incorrect with respect to Statement 1.

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Effective duration is a better measure than modified duration for bonds with embedded options because modified duration does not explicitly recognize the change in cash flows that will occur in a bond with embedded options as yield changes. Therefore, Statement 1 is incorrect. The other four statements made by Spears are correct.

honeycfa

A non-callable bond with 4 years remaining maturity has an annual coupon of 12% and a $1,000 par value. The current price of the bond is $1,063.40. Given a change in yield of 50 basis points, which of the following is closest to the effective duration of the bond?

A) 3.11.

B) 2.94.

C) 3.27.

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First, find the current yield to maturity of the bond as:

FV = $1,000; PMT = $120; N = 4; PV = –$1,063.40; CPT → I/Y = 10%

Then compute the price of the bond if rates rise by 50 basis points to 10.5% as:

FV = $1,000; PMT = $120; N = 4; I/Y = 10.5%; CPT → PV = –$1,047.04

Then compute the price of the bond if rates fall by 50 basis points to 9.5% as:

FV = $1,000; PMT = $120; N = 4; I/Y = 9.5%; CPT → PV = –$1,080.11

The formula for effective duration is:

(V_-–V₊) / (2V₀Δy)

Therefore, effective duration is:

($1,080.11 – $1,047.04) / (2 × $1,063.40 × 0.005) = 3.11

honeycfa

Consider an annual coupon bond with the following characteristics:

• Face value of $100
• Time to maturity of 12 years
• Coupon rate of 6.50%
• Issued at par
• Call price of 101.75 (assume the bond price will not exceed this price)

For a 75 basis point change in interest rates, the bond's duration is:

A) 5.09 years.

B) 8.79 years.

C) 8.17 years.

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Since the bond has an embedded option, we will use the formula for effective duration. (This formula is the same as the formula for modified duration, except that the “upper price bound” is replaced by the call price.) Thus, we only need to calculate the price if the yield increases 75 basis points, or 0.75%.

Price if yield increases 0.75%: FV = 100; I/Y = 6.50 + 0.75 = 7.25; N = 12; PMT = 6.5; CPT → PV = 94.12

The formula for effective duration is

Where:
V-	= call price/price ceiling
V+	= estimated price if yield increases by a given amount, Dy
V0	= initial observed bond price
Dy	= change in required yield, in decimal form

Here, effective duration = (101.75 – 94.12) / (2 × 100 × 0.0075) = 7.63 / 1.5 = 5.09 years.

honeycfa

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

honeycfa

A 30-year semi-annual coupon bond issued today with market rates at 6.75% pays a 6.75% coupon. If the market yield declines by 30 basis points, the price increases to $1,039.59. If the market yield rises by 30 basis points, the price decreases to $962.77. Which of the following choices is closest to the approximate percentage change in price for a 100 basis point change in the market interest rate?

A) 12.80%.

B) 3.84%.

C) 1.28%.

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Approximate % change in price =

(price if yield down – price if yield up) / (2 × initial price × yield change expressed as a decimal).

Here, the initial price is par, or $1,000 because we are told the bond was issued today at par. So, the calculation is: (1039.59 – 962.77) / (2 × 1000 × 0.003) = 76.82 / 6.00 = 12.80.

honeycfa

A bond with a yield to maturity of 8.0% is priced at 96.00. If its yield increases to 8.3% its price will decrease to 94.06. If its yield decreases to 7.7% its price will increase to 98.47. The effective duration of the bond is closest to:

A) 2.75.

B) 7.66.

C) 4.34.

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The change in the yield is 30 basis points.

Duration = (98.47 ? 94.06) / (2 × 96.00 × 0.003) = 7.6563.

honeycfa

A non-callable bond with 18 years remaining maturity has an annual coupon of 7% and a $1,000 par value. The current yield to maturity on the bond is 8%. Which of the following is closest to the effective duration of the bond?

A) 8.24.

B) 9.63.

C) 11.89.

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First, compute the current price of the bond as:

FV = $1,000; PMT = $70; N = 18; I/Y = 8%; CPT → PV = –$906.28

Next, change the yield by plus-or-minus the same amount. The amount of the change can be any value you like. Here we will use ±50 basis points.

Compute the price of the bond if rates rise by 50 basis points to 8.5% as:

FV = $1,000; PMT = $70; N = 18; I/Y = 8.5%; CPT → PV = –$864.17

Then compute the price of the bond if rates fall by 50 basis points to 7.5% as:

FV = $1,000; PMT = $70; N = 18; I/Y = 7.5%; CPT → PV = –$951.47

The formula for effective duration is:

(V_- – V₊) / (2V₀Δy)

Therefore, effective duration is:

($951.47 – $864.17) / (2 × $906.28 × 0.005) = 9.63.

honeycfa

Calculate the effective duration for a 7-year bond with the following characteristics:

• Current price of $660
• A price of $639 when interest rates rise 50 basis points
• A price of $684 when interest rates fall 50 basis points

A) 6.8.

B) 3.1.

C) 6.5.

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The formula for calculating the effective duration of a bond is:

where:

• V_- = bond value if the yield decreases by ?y

• V₊ = bond value if the yield increases by ?y

• V₀ = initial bond price

• ?y = yield change used to get V_- and V₊, expressed in decimal form

The duration of this bond is calculated as:

honeycfa

If bond prices fall 5% in response to a 0.5% increase in interest rates, what is the bond's effective duration?

A) -5.

B) +10.

C) -10.

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Approximate percentage price change of a bond = - (duration) (delta y) =
-5 = - (duration) (0.5) = 10.

honeycfa

When interest rates increase, the duration of a 30-year bond selling at a discount:

A) increases.

B) does not change.

C) decreases.

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The higher the yield on a bond the lower the price volatility (duration) will be. When interest rates increase the price of the bond will decrease and the yield will increase because the current yield = (annual cash coupon payment) / (bond price). As the bond price decreases the yield increases and the price volatility (duration) will decrease.