dkishore1

Steve Jacobs, CFA, is analyzing the price volatility of Bond Q. Q’s effective duration is 7.3, and its effective convexity is 91.2. What is the estimated price change for Bond Q if interest rates fall/rise by 125 basis points?

Fall

Rise

A) +7.70% −10.55%

B) +10.55% −7.70%

C) −10.55% +7.70%

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Estimated change if rates fall by 125 basis points:

(-7.3 × -0.0125) + (91.2)(0.0125)2 = 0.1055 or 10.55%


Estimated change if rates rise by 125 basis points:

(-7.3 × 0.0125) + (91.2)(0.0125)2 = -0.0770 or -7.70%

dkishore1

An analyst has constructed an interest rate tree for an on-the-run Treasury security. The analyst now wishes to use the tree to calculate the convexity of a callable corporate bond with maturity and coupon equal to that of the Treasury security. The usual way to do this is to calculate the option-adjusted spread (OAS):

A) compute the convexity of the Treasury security, and divide by (1+OAS).

B) compute the convexity of the Treasury security, and add the OAS.

C) shift the Treasury yield curve, compute the new forward rates, add the OAS to those forward rates, enter the adjusted values into the interest rate tree, and then use the usual convexity formula.

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The analyst uses the usual convexity formula, where the upper and lower values of the bonds are determined using the tree.

dkishore1

An analyst has constructed an interest rate tree for an on-the-run Treasury security. The analyst now wishes to use the tree to calculate the duration of the Treasury security. The usual way to do this is to estimate the changes in the bond’s price associated with a:

A) parallel shift up and down of the forward rates implied by the binomial model.

B) parallel shift up and down of the yield curve.

C) shift up and down in the current one-year spot rate all else held constant.

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The usual method is to apply parallel shifts to the yield curve, use those curves to compute new sets of forward rates, and then enter each set of rates into the interest rate tree. The resulting volatility of the present value of the bond is the measure of effective duration.

dkishore1

Which of the following most accurately explains how the effective convexity is computed using the binomial model. In order to compute the effective convexity the:

A) yield curve has to be shifted upward and downward in a parallel manner and the binomial tree recalculated each time.

B) binomial tree has to be shifted upward and downward by the same amount for all nodes.

C) volatility has to be shifted upward and downward and the binomial tree recalculated each time.

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Apply parallel shifts to the yield curve and use these curves to compute new forward rates in the interest rate tree. The resulting bond values are then used to compute the effective convexity.

dkishore1

Which of the following correctly explains how the effective duration is computed using the binomial model. In order to compute the effective duration the:

A) binomial tree has to be shifted upward and downward by the same amount for all nodes.

B) yield curve has to be shifted upward and downward in a parallel manner and the binomial tree recalculated each time.

C) the nodal probabilities are shifted upward and downward and the binomial tree recalculated each time.

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Apply parallel shifts to the yield curve and use these curves to compute new forward rates in the interest rate tree. The resulting bond values are then used to compute the effective duration.

dkishore1

An analyst has constructed an interest rate tree for an on-the-run Treasury security. Given equal maturity and coupon, which of the following would have the highest option-adjusted spread?

A) A putable corporate bond with a AAA rating.

B) A putable corporate bond with a Aaa rating.

C) A callable corporate bond with a Baa rating.

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The bond with the lowest price will have the highest option-adjusted spread. All other things equal, the callable bond with the lowest rating will have the lowest price.

dkishore1

Which kind of risk remains if the option-adjusted spread is deducted from the nominal spread?

A) credit risk.

B) option risk.

C) liquidity risk.

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The OAS captures the amount of credit risk and liquidity risk.

dkishore1

Which part of the nominal spread does the option-adjusted spread (OAS) capture?

A) credit and liquidity risk.

B) interest rate and volatility risk.

C) option risk.

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The OAS removes the amount that is due to option risk from the nominal spread leaving just the credit and liquidity risk.

dkishore1

As the volatility of interest rates increases, the value of a putable bond will:

A) rise.

B) decline.

C) rise if the interest rate is below the coupon rate, and fall if the interest rate is above the coupon rate.

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As volatility increases, so will the option value, which means the value of a putable bond will rise. Remember that with a putable bond, the investor is long the put option.

dkishore1

On a given day, a bond with a call provision rose in value by 1%. What can be said about the level and volatility of interest rates?

A) The only possible explanation is that level of interest rates fell.

B) A possibility is that the level of interest rates remained constant, but the volatility of interest rates fell.

C) A possibility is that the level of interest rates remained constant, but the volatility of interest rates rose.

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As volatility declines, so will the option value, which means the value of a callable bond will rise.