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LOS e, (Part 1): Distinguish among the alternative definitions of duration.

Q1. The goal of computing effective duration is to get a:

A)   preliminary estimate of modified duration.

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

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

Q2. When compared to modified duration, effective duration:

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

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

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

Q3. Which of the following statements about modified duration and effective duration is FALSE?

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.

Q4. 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%.

Q5. When calculating duration, which of the following bonds would an investor least likely use effective duration on rather than modified duration?

A)   Callable bond.

B)   Convertible bond.

C)   Option-free bond.

Q6. Which of the following statements about duration and convexity is FALSE?

A)   convexity of a callable bond is always lower than that of a noncallable bond when rates fall.

B)   option-adjusted duration cannot exceed duration to maturity.

C)   duration to first call is longer than duration to maturity.

Q7. Which of the following statements about duration is FALSE?

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.

Q8. 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

LOS e, (Part 1): Distinguish among the alternative definitions of duration.fficeffice" />

Q1. The goal of computing effective duration is to get a:

A)   preliminary estimate of modified duration.

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

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

Correct answer is C)

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.

Q2. When compared to modified duration, effective duration:

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

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

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

Correct answer is A)

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

Q3. Which of the following statements about modified duration and effective duration is FALSE?

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.

Correct answer is A)

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.

Q4. 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%.

Correct answer is A)

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.

Q5. When calculating duration, which of the following bonds would an investor least likely use effective duration on rather than modified duration?

A)   Callable bond.

B)   Convertible bond.

C)   Option-free bond.

Correct answer is C)

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.

Q6. Which of the following statements about duration and convexity is FALSE?

A)   convexity of a callable bond is always lower than that of a noncallable bond when rates fall.

B)   option-adjusted duration cannot exceed duration to maturity.

C)   duration to first call is longer than duration to maturity.

Correct answer is C)

Duration to maturity is longer than duration to first call because one measure of duration is the time until maturity or until the bond is called. Since the time until the first call is shorter than if the bond was not called the duration to first call is shorter than duration to maturity.

Q7. Which of the following statements about duration is FALSE?

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.

Correct answer is A)

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

Q8. An investor gathered the following information on two ffice:smarttags" />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

Correct answer is C)

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.

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