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    Question

    A pension-oriented fund holds callable bonds which

    exhibit negative convexity as rates fall. When rates dropped 1%, bond price only increased 0.8% instead of the 1.2% you'd expect on positive convexity. What happened and how to respond?
    A Reinvest proceeds Correct Answer Incorrect Answer
    B Purchase discount bonds Correct Answer Incorrect Answer
    C Buy interest rate caps Correct Answer Incorrect Answer
    D Sell callable bonds to reduce risk Correct Answer Incorrect Answer
    E No action Correct Answer Incorrect Answer

    Solution

    Callable bonds limit price upside (negative convexity). To reduce mismatch and restore convexity, the fund should sell callable bonds and replace with non-callables or use caps to mitigate imbedded options.

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