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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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