Could someone help me to understand this concept?
Q: For large changes in yield, which of the following statements about using duration to estimate price changes is most accurate? Duration alone:
A: overestimates the increase in price for decreases in yield.
B: overestimates the increase in price for increases in yield.
C: underestimates the increase in price for decreases in yield.
Correct answer: C
Draw a price-yield curve for a straight bond.
Draw a straight line tangent to that curve at some point.
Note whether the price change on the curve (from the tangency point to some other point) is greater than or less than the price change along the tangent line.
There’s your answer.
Note that it’s a lousy question, because it needed to specify that this is, at the very least, a noncallable bond; preferably, a bond with no embedded options (a straight bond).
Thanks so much, I understood that increase in the price will be more about but confused about the overestimates and underestimates statements meaning answer a or c. Please help. I tried to paste the image but it seems, it doesn’t show it here.
Just compare these two statements with the answer choices and hope it will clear your confusion:
Duration _ underestimates _ the increase in price for a decrease in yield (Graph - top left)
Duration _ overestimates _ the decrease in price for an _ increase _ in yield (Graph - bottom right)
The above two statements are correct and the 1st one matches answer choice c.
Tip for the exam: Draw the graph, write these two statements in short hand and match with correct answer choice, otherwise focusing only on the answer choices leads to confusion.
All the best.
thanks so much! It does make sense now:)