7. 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 6 months.

Characteristic CIC PTR Market price 101.75 101.75 Maturity date June 1, 2019 June 1, 2019 Call date Noncallable June 1, 2014 Annual coupon 6.25% 7.35%

Interest payment Semiannual Semiannual Effective duration 7.35 5.40 Yield to maturity 6.02% 7.10%

Credit rating A A

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 6 months.

b. Calculate the 6-month horizon return (in percent) for each bond, if the actual CIC bond price equals 105.55 and the actual PTR bond price equals 104.15 at the end of 6 months. Assume you purchased the bonds to settle on June 1, 2009.

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 the actual price change would be less for the PTR bond.