Question

An investor is considering 3 purchasing different Bonds.

Bond X pays a coupon rate of 2% and matures in 12 years.

Bond Y pays a coupon rate of 4% and matures in 12 years.

Bond Z pays a coupon rate of 4% and matures in 7 years.

For a 300 basis point increase in the required rate of return:

Bond X will most likely exhibit a smaller percent decrease price than Bond Y.

Bond X will most likely exhibit a larger percent increase in price than Bond Y.

Bond X will most likely exhibit a smaller percent increase in price than Bond Y

Bond X will most likely exhibit a larger percent decrease in price than Bond Y.

None of the other answers are correct.

Answer 1

Bond X will most likely exhibit a larger percent decrease in price than Bond Y.

Between Bond X and Bond Y, only coupon rate is different. We know, duration is inversely proportional to coupon rate. Hence, duration of Bond X is greater than duration of Bond Y.

With 300 basis point increase in the required rate, th price of both the bonds will fall, with the price of Bond X falling more than price of bond Y due to its greater duration.

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