You are an investment consultant working for a superannuation firm. One of the fixed-income portfolio managers wants to understand more about managing interest rate risk in the portfolio, and she is particularly interested in understanding the concept of duration. The portfolio currently contains option free bonds but the manager is considering adding bonds with embedded options into the portfolio. The manager is also considering purchasing a three-year 8% annual coupon paying bond.

An investor buys a 6% annual payment bond with 3 years to maturity. The bond has a yield-to-maturity of 7%. The bond's modified duration is closest to

[3 marks]

2. Suppose the manager has now added a new bond with embedded option. You find that the value of the new bond with embedded option is $92. Using your price technique, you find that the value of a normal bond (i.e. option free) with similar characteristics is worth $90 and the value of the option is $2. The embedded option is most likely:

• Call option
• Put option

Based on your answer, please indicate below by circling whom does the embedded option benefit and explain your answers.

• Issuer
• Investors

[4 marks]