Question

Which of the following bonds has the longest duration?

		7-year, 7% coupon bond
		7-year, 12% coupon bond
		14-year, 7% coupon bond
		14-year, 12% coupon bond

Answer 1

Bonds are financial instruments which provide fixed returns to its holders. Bonds actually have a nature of debt with a fixed interest rate and a maturity, also known as Plain Vanilla Bond. Some bonds have a callability feature which enables the issuer to call and buy back the bonds from the bondholders.

Bond duration is the measure of the responsiveness of the bond price with respect to movements in interest rates.

The duration of a bond depends on various factors:

• Maturity - the longer the maturity of the bond, the higher will be its duration. And bonds maturing early will have a shorter duration.

Thus, the 7-year bonds have been ruled out. Since there are 14-year bonds that will have a longer duration than the 7-year bonds.

• Coupon Rate - Bonds having a higher coupon rate tend to have a shorter duration than the bonds that have lower coupon rate as it repays the amount faster.

Therefore, out of the remaining two 14-year bonds, the bond having a lower coupon rate will have the highest duration.

Thus, duration will be maximum for bonds that have a longer maturity and lower coupon rate.

14 year, 7% coupon Bond will have the highest Duration.