Question

Which of the following is correct?

A. For a 10 year bond with a 9% annual coupon and a yield to maturity of 8%, if the yield to maturity remains constant, the bonds capital gains yield will be negative.

B. The longer the time ti maturity, the greater the change in the value of a bond in response to a given change in interest rates.

C. All of the above are correct.

D. None of the above are correct.

Answer 1

Answer is

option C. All of the above are correct

1)Yield to maturity is the return given by a bond . The return given by a bond includes the coupon payments as well as capital gain or capital loss. It is given that the coupon is 9% but the yield is only 8%. This indicates that the coupon of 1%(9%-8%) has been eroded by capital loss. Hence option A is correct.

2)The change in value of a bond in response to a given change in interest rates is indicated by Volatility.

Volatility of a bond is the percentage change in price of a bond when there is a change in yield. For example if the yield from a bond is to increase , we can expect the price of the bond to decrease.

Volatility can be calculated using the formula

V=

From the above formula , we can observe that volatility increases with duration.

It is known that duration of a bond is directly proportional to the time of maturity of bond .

Hence it can be concluded that volatility increases with duration and duration increases with time of maturity. Therefore volatility (Change in value of a bond in response to change in interest rates) increases with time of maturity of a bond.

• Malkiel's theories also postulate that long term bonds have higher price sensitivity with respect to a change in interest rates

Hence Option B is correct

Note-Duration can be understood as the average period for which money is blocked in the bond instrument.