Risk and Return

Question 1

The current price of a $1,000 par value, 6-year, 4.2% semiannual coupon bond is $958.97. The bond’s price value of a basis point is closest to:

Answer 1

First we compute the yield to maturity of the bond. PV = –$958.97, FV = $1,000, PMT = $21, N = 12, CPT I/Y = 2.5%, multiply by 2 since it is a semiannual bond to get an annualized yield to maturity of 5.0%. Now compute the price of the bond at using yield one basis point higher, or 5.01%. FV = $1,000, PMT = 21, N = 12, I/Y = (5.01 / 2 =) 2.505, CPT PV = –$958.47. The price changes from $958.97 to $958.47, or $0.50.

(Module 46.2, LOS 46.g)

Question 2

Jayce Arnold, a CFA candidate, 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:

Answer 2

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.

Question 3

Duration and convexity are most likely to produce more accurate estimates of interest rate risk when the term structure of yield volatility is:

Answer 3

Duration and convexity assume the yield curve shifts in a parallel manner. A downward (upward) sloping term structure of yield volatility suggests shifts in the yield curve are likely to be non-parallel because short-term interest rates are more (less) volatile than long-term interest rates.

(Module 46.3, LOS 46.j)

Question 4

All else being equal, which of the following bond characteristics most likely results in less reinvestment risk?

Answer 4

Other things being equal, the amount of reinvestment risk embedded in a bond will decrease with lower coupons as there are fewer coupons to reinvest and with shorter maturities because the reinvestment period is shorter.

A lower Macaulay duration may reflect more or less reinvestment risk, depending on what causes Macaulay duration to be lower. A lower Macaulay duration could result from a shorter maturity (which reduces reinvestment risk) or a higher coupon (which increases reinvestment risk).

(Module 46.1, LOS 46.a)