Patrick Wall is considering the purchase of one of the two bonds described in the following table.
Question:
Patrick Wall is considering the purchase of one of the two bonds described in the following table.
Wall realizes his decision will depend primarily on effective duration, and he believes that interest rates will decline by 50 basis points at all maturities over the next six months. P-963 Bond Rating Initial Spread over Governments Expected Horizon Spread Initial Duration Expected Duration 1 Year from Now Aaa 31 b.p. 31 b.p. 4 years 3.1 years Aa 40 b.p. 50 b.p. 4 years 3.1 years Note: 1 b.p. = 1 basis point, or .01%.
a. Calculate the percentage price change forecasted by effective duration for both the CIC and PTR bonds if interest rates decline by 50 basis points over the next six months.
b. Calculate the 6-month horizon return (in percent) for each bond if the CIC bond price at the end of six months equals 105.55 and the PTR bond price equals 104.15.
c. Wall is surprised by the fact that although interest rates fell by 50 basis points, the actual price change for the CIC bond was greater than the price change forecasted by effective duration, whereas the actual price change for the PTR bond was less than the price change forecasted by effective duration. Explain why the actual price change would be greater for the CIC bond and less for the PTR bond.
Step by Step Answer:
ISE Investments
ISBN: 9781266085963
13th International Edition
Authors: Zvi Bodie, Alex Kane, Alan Marcus