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      Question

      The concept of 'duration' in fixed income investing

      measures which of the following?
      A The remaining life of a bond from today to its final maturity date Correct Answer Incorrect Answer
      B The number of coupon payments remaining before a bond matures Correct Answer Incorrect Answer
      C A bond's price sensitivity to changes in interest rates the higher the duration, the greater the price change for a given change in yield Correct Answer Incorrect Answer
      D The credit risk of a bond, measured as the probability of default over its remaining life Correct Answer Incorrect Answer
      E The time taken for a bond to be settled after purchase in the secondary market Correct Answer Incorrect Answer

      Solution

      Duration is a measure of a fixed-income security's sensitivity to changes in interest rates. More precisely, modified duration estimates the percentage change in a bond's price for a 1% (100 basis points) change in yield. A bond with a duration of 5 years will approximately lose 5% of its price if interest rates rise by 1%. Duration is not simply the time to maturity it is a weighted average of the times at which the bond's cash flows are received, weighted by the present value of those cash flows. Zero-coupon bonds have the highest duration (equal to their maturity) because all cash flows occur at maturity. Bonds with higher coupons have lower duration because a greater proportion of cash flows are received earlier.

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