CFA Chapter 16 PROBLEMS

1. A 6% coupon bond paying interest annually has a modified duration of 10 years,

sells for $800, and is priced at a yield to maturity of 8%.
a. If the YTM increases to 9%, what is the predicted change in price using the duration
concept?
b. A 6% coupon bond with semiannual coupons has a convexity (in years) of 120, sells
for 80% of par, and is priced at a yield to maturity of 8%. If the YTM increases to
9.5%, what is the predicted contribution to the percentage change in price due to
convexity?
c. A bond with annual coupon payments has a coupon rate of 8%, yield to maturity of
10%, and Macaulay duration of 9 years. What is the bond’s modified duration?
d. When interest rates decline, the duration of a 30-year bond selling at a premium:
i. Increases.
ii. Decreases.
iii. Remains the same.
iv. Increases at first, then declines.
e. If a bond manager swaps a bond for one that is identical in terms of coupon rate,
maturity, and credit quality but offers a higher yield to maturity, the swap is:
i. A substitution swap.
ii. An interest rate anticipation swap.
iii. A tax swap.
iv. An intermarket spread swap.
f. Which bond has the longest duration?
i. 8-year maturity, 6% coupon.
ii. 8-year maturity, 11% coupon.
iii. 15-year maturity, 6% coupon.
iv. 15-year maturity, 11% coupon.
2. A newly issued bond has the following characteristics:

Coupon Yield to Maturity Maturity Macaulay’s

Duration

8% 8% 15years 10years

a. Calculate modified duration using the information above.

b. Explain why modified duration is a better measure than maturity when calculating
the bond’s sensitivity to changes in interest rates.
c. Identify the direction of change in modified duration if: i. The coupon of the bond
were 4%, not 8%.ii. The maturity of the bond were 7 years, not 15 years.
d. Define convexity and explain how modified duration and convexity are used to
approximate the bond’s percentage change in price, given a change in interest
rates.
3. Noah Kramer, a fixed-income portfolio manager based in the country of Sevista, is
considering the purchase of a Sevista government bond. Kramer decides to evaluate two
strategies for implementing his investment in Sevista bonds. Table A gives the details of
the two strategies, and Table B contains the assumptions that apply to both strategies.

Before choosing one of the two bond-investment strategies, Kramer wants to analyze
how the market value of the bonds will change if an instantaneous interest rate shift
occurs immediately after his investment. The details of the interest rate shift are shown
in Table C. Calculate, for the instantaneous interest rate shift shown in Table C, the
percent change in the market value of the bonds that will occur under each strategy.

Table A:

Strategy 5-Year Maturity 15-Year Maturity 25-Year Maturity

(Modified (Modified (Modified
Duration=4.83) Duration=14.35) Duration=23.81)

I $5million 0 $5million

II 0 $10million 0

Table B:

Market value of bonds $10million

Bond maturities 5 and 25 years or 15 years

Bond coupon rates 0.00% (zero coupon)

Target modified duration 15 years

Table C:

Maturity Interest Rate Change

5 year Down 75 Basis points(bps)

15 year Up 25 bps

25 year Up 50 bps
Chapter 16 CFA PROBLEMS

1. a. Bond price decreases by $80.00, calculated as follows:

10 × 0.01 × 800 = 80.00

b. ½ × 120 × (0.015)2 = 0.0135 = 1.35%

c. 9/1.10 = 8.18

d. (i)

e. (i)

f. (iii)

Macaulay duration 10
= = =9 .26
2. a. Modified duration 1+YTM 1 . 08 years
b. For option-free coupon bonds, modified duration is a better measure of the
bond’s sensitivity to changes in interest rates. Maturity considers only the
final cash flow, while modified duration includes other factors, such as the
size and timing of coupon payments, and the level of interest rates (yield to
maturity). Modified duration indicates the approximate percentage change in
the bond price for a given change in yield to maturity.

c. i. Modified duration increases as the coupon decreases.

ii. Modified duration decreases as maturity decreases.

d. Convexity measures the curvature of the bond’s price-yield curve. Such

curvature means that the duration rule for bond price change (which is based
only on the slope of the curve at the original yield) is only an approximation.
Adding a term to account for the convexity of the bond increases the
accuracy of the approximation. That convexity adjustment is the last term in
the following equation:
P 1 
 ( D*  y )    Convexity  (y ) 2 
P 2 

3. ∆P/P = −D* ∆y
For Strategy I:
5-year maturity: ∆P/P = −4.83 × (−0.75%) = 3.6225%
25-year maturity: ∆P/P = −23.81 × 0.50% = −11.9050%
Strategy I: ∆P/P = (0.5 × 3.6225%) + [0.5 × (−11.9050%)] = −4.1413%
For Strategy II:
15-year maturity: ∆P/P = −14.35 × 0.25% = −3.5875%