1. Assume today is 1 October 2011. You are an active bond portfolio manager and your portfolio currently comprises two bonds, A and B. Characteristics Bond A Bond B Face Value R1,000 R1,000 Coupon Rate 11% pa 9.5% pa, payable annually Maturity 30 September 2017 30 September 2015 Yield to Maturity 10% 10% Price R1,043.55 R984.15 Convexity 25.03 13.82 Macaulay Duration 4.73 3.50 a) Assume that you expect interest rates in the market to decrease by 2%. Without calculating the resulting price changes in the bonds, which bond would you prefer to hold? Why? (5marks) b) Briefly discuss the attributes Bond A would have to exhibit in order for its price to be considered less sensitive to changes in interest rates. (4marks) c) Use the information provided above for one of the bonds to illustrate that duration is only an approximation of bond prices in light of the expected 2% change in interest rates. (5marks) d) What impact does bond convexity have on changes in a bond's price? Illustrate the attractiveness of convexity to bond investors using your calculations in (c) and the information provided in the table. (5 marks) e) Assume that we practiced interest rate forecasting in managing our portfolio. How would we respond to the expected 2% decrease in interest rates? (3 marks) 2. What are the limitations of using duration as a measure of a bond's price sensitivity to interest- rate changes? (5marks)