Question says what is the return impact to an investor in a bond given an increase of 66 basis points. Answer gives: - (modified duration x change in spread) + (0.5 x convexity x (change in spread^2)) In Schweser, I have seen the change in bond price is given by: [- (effective duration x change in spread) + (effective convexity x (change in spread^2)] x 100. 1. Why does the answer for this question use modified while Schweser uses effective? 2. Why does the answer for this question x 0.5?
If the bond has no risk of cash flow changes (no embedded options, fixed coupon), modified duration is the same as effective duration; use whichever they give you. If the bond has embedded options or a floating coupon (so that the cash flows could change when the YTM changes), then you have to use effective duration. Thus, effective duration is correct in all cases; it’s more general.
Take a look at the article I wrote on convexity (the last bit on the controversy): http://financialexamhelp123.com/convexity/.
great thanks
My pleasure.