andytrader

Effective duration is more appropriate than modified duration as a measure of a bond's price sensitivity to yield changes when:

A) the bond has a low coupon rate and a long maturity.

B) yield curve changes are not parallel.

C) the bond contains embedded options.

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Effective duration takes into consideration embedded options in the bond. Modified duration does not consider the effect of embedded options. For option-free bonds, modified duration will be similar to effective duration. Both duration measures are based on the value impact of a parallel shift in a flat yield curve.

andytrader

Which of the following statements about duration is most accurate?

A) Modified duration is the most appropriate measure of interest rate sensitivity for bonds with embedded options.

B) Effective duration accounts for changes in a bond’s cash flows resulting from interest rate changes.

C) Effective duration is calculated from past price changes in response to changes in yield.

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Neither Macaulay nor modified duration is an appropriate measure of interest rate risk for bonds with embedded options. Macaulay duration does not take the current YTM into account as modified duration does. Effective duration, however, explicitly takes into account changes in a bond’s cash flows due to interest rate changes and is calculated from expected price changes in response to a given increase or decrease in yield.

andytrader

Vijay Ranjin, CFA, is a portfolio manager with Golson Investment Group. He manages a fixed-coupon bond portfolio with a face value of $120.75 million and a current market value of $116.46 million. Golson’s economics department has forecast that interest rates are going to change by 50 basis points. Based on this forecast, Ranjin estimates that the portfolio’s value will increase by $2.12 million if interest rates fall and will decrease by $2.07 million if interest rates rise. Which of the following choices is closest to the portfolio’s effective duration?

A) 4.3.

B) 0.4.

C) 3.6.

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Effective duration = (price when interest rates fall − price when interest rates rise) / (2 × initial price × basis point change)
= (118.58 – 114.39) / (2 × 116.46 × 0.005) = 3.60.

andytrader

Which of the following statements about portfolio duration is NOT correct? It is:

A) a measure of interest rate risk.

B) a simple average of the duration estimates of the securities in the portfolio.

C) the weighted average of the duration estimates of the securities in the portfolio.

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Portfolio duration uses a weighted average figure, not a simple average.

andytrader

Suppose you have a three-security portfolio containing bonds A, B and C. The effective portfolio duration is 5.9. The market values of bonds A, B and C are $60, $25 and $80, respectively. The durations of bonds A and C are 4.2 and 6.2, respectively. Which of the following amounts is closest to the duration of bond B?

A) 7.4.

B) 1.4.

C) 9.0.

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Plug all the known figures and then solve for the one unknown figure, the duration of bond B.
Proof: (60/165 × 4.2) + (25/165 × 9.0) + (80/165 × 6.2) = 5.9

andytrader

A bond portfolio consists of a AAA bond, a AA bond, and an A bond. The prices of the bonds are $1,050, $1,000, and $950 respectively. The durations are 8, 6, and 4 respectively. What is the duration of the portfolio?

A) 6.00.

B) 6.07.

C) 6.67.

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The duration of a bond portfolio is the weighted average of the durations of the bonds in the portfolio. The weights are the value of each bond divided by the value of the portfolio:

portfolio duration = 8 × (1050 / 3000) + 6 × (1000 / 3000) + 4 × (950 / 3000) = 2.8 + 2 + 1.27 = 6.07.

andytrader

Which of the following is a limitation of the portfolio duration measure? Portfolio duration only considers:

A) a linear approximation of the actual price-yield function for the portfolio.

B) the market values of the bonds.

C) a nonparallel shift in the yield curve.

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Duration is a linear approximation of a nonlinear function. The use of market values has no direct effect on the inherent limitation of the portfolio duration measure. Duration assumes a parallel shift in the yield curve, and this is an additional limitation.

andytrader

Which of the following is NOT a limitation of the portfolio duration measure?

A) It is subject to huge swings in value since book values may change over time.

B) It assumes that the yield for all maturities changes by the same amount.

C) It is subject to huge swings in value since market values may change over time.

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Bond duration is calculated using market values; changes in book values are irrelevant.

andytrader

Which of the following is the most significant limitation of the portfolio duration measure? The assumption of:

A) a nonparallel shift in the yield curve.

B) a linear approximation of the actual price-yield function.

C) a parallel shift in the yield curve.

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The most significant limitation of portfolio duration is the assumption that the yield for all maturities changes by the same amount (a parallel shift in the yield curve).

andytrader

How does the convexity of a bond influence the yield on the bond? All else the same, for a bond with high convexity investors will require:

A) a higher or lower yield depending on the bond's duration.

B) a higher yield.

C) a lower yield.

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Convexity is to the advantage of the bond holder because a high-convexity bond's price will decrease less when rates increase and will increase more when rates decrease than a low-convexity bond's price.