mouse123

The price of a bond is equal to $101.76 if the term structure of interest rates is flat at 5%. The following bond prices are given for up and down shifts of the term structure of interest rates. Using the following information what is the approximate percentage price change of the bond using effective duration and assuming interest rates decrease by 0.5%?

Bond price: $98.46 if term structure of interest rates is flat at 6%
Bond price: $105.56 if term structure of interest rates is flat at 4%

A) 1.74%.

B) 0.174%.

C) 0.0087%.

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The effective duration is computed as follows:

Using the effective duration, the approximate percentage price change of the bond is computed as follows:

Percent price change = -3.49 × (-0.005) × 100 = 1.74%

mouse123

Which of the following statements about duration is NOT correct

A) Effective duration is the exact change in price due to a 100 basis point change in rates.

B) For a specific bond, the effective duration formula results in a value of 8.80%. For a 50 basis point change in yield, the approximate change in price of the bond would be 4.40%.

C) The numerator of the effective duration formula assumes that market rates increase and decrease by the same number of basis points.

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Effective duration is an approximation because the duration calculation ignores the curvature in the price/yield graph.

mouse123

When calculating duration, which of the following bonds would an investor least likely use effective duration on rather than modified duration?

A) Option-free bond.

B) Callable bond.

C) Convertible bond.

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The duration computation remains the same. The only difference between modified and effective duration is that effective duration is used for bonds with embedded options. Modified duration assumes that all the cash flows on the bond will not change, while effective duration considers expected cash flow changes that may occur with embedded options.

andytrader

A bond with an 8% semi-annual coupon and 10-year maturity is currently priced at $904.52 to yield 9.5%. If the yield declines to 9%, the bond’s price will increase to $934.96, and if the yield increases to 10%, the bond’s price will decrease to $875.38. Estimate the percentage price change for a 100 basis point change in rates.

A) 6.58%.

B) 4.35%.

C) 2.13%.

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The formula for the percentage price change is: (price when yields fall – price when yields rise) / 2 × (initial price) × 0.005 = ($934.96 – 875.38) / 2($904.52)(0.005) = $59.58 / $9.05 = 6.58%. Note that this formula is also referred to as the bond’s effective duration.

andytrader

Which of the following statements about modified duration and effective duration is NOT correct?

A) Modified duration should be used for bonds with embedded options.

B) Effective duration should be used for bonds with embedded options.

C) The modified duration measure assumes that yield changes do not change the expected cash flows.

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Using modified duration as a measure of the price sensitivity of a security with embedded options to changes in yield would be misleading. With embedded options, yield changes may change the expected cash flows.

andytrader

When compared to modified duration, effective duration:

A) is equal to modified duration for callable bonds but not putable bonds.

B) factors in how embedded options will change expected cash flows.

C) places less weight on recent changes in the bond's ratings.

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The point of effective duration is to consider expected changes in cash flow from features such as embedded options.

andytrader

The goal of computing effective duration is to get a:

A) preliminary estimate of modified duration.

B) more accurate measure of the bond's price sensitivity when embedded options exist.

C) measure of duration that is effectively constant for the life of the bond.

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The point of effective duration is to consider expected changes in cash flow from features such as embedded options. When embedded options exist, the effective duration will give a better measure of the bond’s price sensitivity to interest rate changes.

andytrader

An investor gathered the following information on two U.S. corporate bonds:

Bond J is callable with maturity of 5 years Bond J has a par value of $10,000 Bond M is option-free with a maturity of 5 years
• Bond M has a par value of $1,000

For each bond, which duration calculation should be applied?

Bond J

Bond M

A) Modified Duration Effective Duration only

B) Effective Duration Effective Duration only

C) Effective Duration Modified Duration or Effective Duration

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The duration computation remains the same. The only difference between modified and effective duration is that effective duration is used for bonds with embedded options. Modified duration assumes that all the cash flows on the bond will not change, while effective duration considers expected cash flow changes that may occur with embedded options.

andytrader

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) change with the bond's embedded options.

B) be affected by a convertible bond.

C) not change.

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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.

andytrader

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

C) Effective duration considers expected changes in cash flows.

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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.