LOS c: Describe positive convexity, negative convexity, and their relation to bond price and yield.

Q1. Negative convexity for a callable bond is most likely to be important when the:

A)   price of the bond approaches the call price.

B)   bond is first issued.

C)   market interest rate rises above the bond's coupon rate.

Q2. 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.

Q3. 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)   the same for both bond types.

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

Q4. Which of the following is most accurate about a bond with positive convexity?

A)   Positive changes in yield lead to positive changes in price.

B)   Price increases when yields drop are greater than price decreases when yields rise by the same amount.

C)   Price increases and decreases at a faster rate than the change in yield.

Q5. The convexity of a U.S Treasury bond is usually:

A)   negative.

B)   zero.

C)   positive.

Q6. Which of the following bonds bears the greatest price impact if its yield declines by one percent? A bond with:

A)   30-year maturity and selling at 100.

B)   10-year maturity and selling at 70.

C)   30-year maturity and selling at 70.

Q7. Non-callable bond prices go up faster than they go down. This is referred to as:

A)   negative convexity.

B)   positive convexity.

C)   inverse features.

LOS c: Describe positive convexity, negative convexity, and their relation to bond price and yield.fficeffice" />

Q1. Negative convexity for a callable bond is most likely to be important when the:

A)   price of the bond approaches the call price.

B)   bond is first issued.

C)   market interest rate rises above the bond's coupon rate.

Correct answer is A)

Negative convexity illustrates how the relationship between the price of a bond and market yields changes as the bond price rises and approaches the call price. The convex curve that we generally see for non-callable bonds bends backward to become concave (i.e., exhibit negative convexity) as the bond approaches the call price.

Q2. 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.

Correct answer is C)

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.

Q3. 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)   the same for both bond types.

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

Correct answer is C)

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.

Q4. Which of the following is most accurate about a bond with positive convexity?

A)   Positive changes in yield lead to positive changes in price.

B)   Price increases when yields drop are greater than price decreases when yields rise by the same amount.

C)   Price increases and decreases at a faster rate than the change in yield.

Correct answer is B)

A convex price/yield graph has a larger increase in price as yield decreases than the decrease in price when yields increase.  This comes from the definition of a convex graph.

Q5. The convexity of a U.S Treasury bond is usually:

A)   negative.

B)   zero.

C)   positive.

Correct answer is C)

One characteristic of all noncallable bonds is that they have positive convexity and U.S. Treasury bonds are noncallable bonds.

Q6. Which of the following bonds bears the greatest price impact if its yield declines by one percent? A bond with:

A)   30-year maturity and selling at 100.

B)   10-year maturity and selling at 70.

C)   30-year maturity and selling at 70.

Correct answer is C)

There are three features that determine the magnitude of duration:

(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.

The bond with the 30-year maturity will have a greater price impact than the 10-year maturity. The bond selling at the greatest discount will have a large price impact, a discount means that the coupon payments are low or the initial yield is low. So, the bond with the 30-year maturity and selling at 70 will have the greatest price volatility.

Q7. Non-callable bond prices go up faster than they go down. This is referred to as:

A)   negative convexity.

B)   positive convexity.

C)   inverse features.

Correct answer is B)

When bond prices go up faster than they go down, it is called positive convexity.

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