Doubt in Q-7 Pg 40 , Book 5(L1)--->Risk associated in investing in Bonds

CFA Level I
#1

Hi All, Plz help me understand the answer for Q-7 on Pg 40 book 5. The duration of bond is 5.47 , its current price is $986.30. Which of the following is best estimate of bond price change if interest rates increase by 2%? Answer given is Dollar price change = -5.47*0.02*986.3=-$107.90 Could anyone plz clarify the -ve sign explanation… the answer says that price of bond should decrease as shown by -ve sign. But as per my understanding if interest rates increase yield should decrese and hence price of the bond should infact increase by the same value & not decrease as given in answer. I would appreciate if someone could answer that… Regards Varun

#2

You got your relationships wrong. Overall rates move in the same direction as bond yields, and inversely w/ bond prices.

#3

Thanks ymmt. I guess u are right … its the other way round.If interest rates are higher higher yield is expected & hence nond prices will decrease.

#4

varunynr Wrote: ------------------------------------------------------- > Thanks ymmt. I guess u are right … its the other > way round.If interest rates are higher higher > yield is expected & hence nond prices will > decrease. Exactly

#5

varunynr Wrote: ------------------------------------------------------- > …bond should decrease as shown by -ve sign. But as > per my understanding if interest rates increase > yield should decrese and hence price of the bond > should infact increase by the same value & not > decrease as given in answer. I would appreciate if > someone could answer that… > > Regards > Varun Just remember that the price of the bond (or of any security) is the present value of the expected cash flows, discounted at some (risk-appropriate) interest rate. As the interest rate increases, the present value decreases. Yield and interest rate are often used interchangeably. The coupon rate, however, is fixed at issue (for a “plain vanilla” coupon bond), and does not change.

#6

Hi, please remember this imp relationship Interest rate in mkt increases = Current yield offered by the bond will be less that mkt rate(So price of bond will fall to give interest rate equal to the mkt) For e.g. if 6% is the prevailing mkt rate and a bond of $100 is offering a 6% interest rate then it will be sold at $100. But if rates increase to 8% the bond will be sold at less than $100 so that it offers 8% rate. So, when interest rate increases in the mkt = Prices of existing bonds will fall. In your example as the mkt rates are increasing the price of bond will fall. So duration is -ve.