fabozzi_chapter09

Foundations of Financial Markets and Institutions, 4e (Fabozzi/Modigliani/Jones)

Foundations of Financial Markets and Institutions, 4e (Fabozzi/Modigliani/Jones)

Chapter 9 Properties and Pricing of Financial Assets

Multiple Choice Questions

1 Properties of Financial Assets

1) Which of the below is NOT one of the eleven properties of financial assets?

A) moneyness

B) multiplicity and denomination

C) reversibility

D) cash flow

Answer: B

Comment: The eleven properties of financial assets are (1) moneyness, (2) divisibility and denomination, (3) reversibility, (4) cash flow, (5) term to maturity, (6) convertibility, (7) currency, (8) liquidity, (9) return predictability, (10) complexity, and (11) tax status.

Diff: 2

Topic: 9.1 Properties of Financial AssetsObjective: 9.1 the many key properties of financial assets: moneyness; divisibility and denomination; reversibility; cash flow and return; term to maturity; convertibility; currency; liquidity; return predictability or risk; complexity; and tax status

2) Which of the below is NOT one of the eleven properties of financial assets?

A) convertibility

B) currency

C) liquidity predictability

D) tax status

Answer: C

Comment: The eleven properties of financial assets are (1) moneyness, (2) divisibility and denomination, (3) reversibility, (4) cash flow, (5) term to maturity, (6) convertibility, (7) currency, (8) liquidity, (9) return predictability, (10) complexity, and (11) tax status.

Diff: 2

Topic: 9.1 Properties of Financial Assets

Objective: 9.1 the many key properties of financial assets: moneyness; divisibility and denomination; reversibility; cash flow and return; term to maturity; convertibility; currency; liquidity; return predictability or risk; complexity; and tax status

3) Which of the below are THREE of the eleven properties of financial assets?

A) return predictability, complexity, and tax status

B) convertibility, currency, liquidity

C) liquidity, reversibility, and cash flow

D) money, divisibility, and denomination

Answer: D

Comment: The 11 properties of financial assets are (1) moneyness, (2) divisibility and denomination (these are only ONE property and not TWO), (3) reversibility, (4) cash flow, (5) term to maturity, (6) convertibility, (7) currency, (8) liquidity, (9) return predictability, (10) complexity, and (11) tax status.

Diff: 2



4) Which of the below statements is TRUE?

A) "Near money" is a financial asset that is used as a medium of exchange or in settlement of transactions.

B) In the United States, money consists of currency and a very few forms of deposits that permit check writing.

C) "Near money" is very close to "money" in that it can be transformed into money at little cost, delay, or risk.

D) "Faraway money", in the case of the United States, includes (i) time and savings deposits and (ii) a security issued by the U.S. government called a Treasury bill.

Answer: C

Comment: Money is a financial asset that is used as a medium of exchange or in settlement of transactions. In the United States, money consists of currency and all forms of deposits that permit check writing. "Near money", in the case of the United States, includes (i) time and savings deposits and (ii) a security issued by the U.S. government called a Treasury bill.

Diff: 2



5) ________ relates to the minimum size in which a financial asset can be liquidated and exchanged for money.

A) Reversibility

B) Denomination

C) Convertibility

D) Divisibility

Answer: D

Diff: 1



6) Reversibility is referred to as ________.

A) the cost of investing in a financial asset and then getting out of it but not back into cash again.

B) the cost of investing in a financial asset instead of investing in cash.

C) one-way cost

D) turnaround cost

Answer: D

Comment: Reversibility refers to the cost of investing in a financial asset and then getting out of it and back into cash again. Consequently, reversibility is also referred to as turnaround cost or round-trip cost.

Diff: 2



7) The ________, the greater the probability of the market maker ________ in excess of a stated bound between the time of buying and reselling the financial asset.

A) greater the variability; incurring a loss

B) lesser the variability; incurring a loss

C) lesser the variability; incurring a large gain

D) greater the variability; incurring no loss or gain

Answer: A

Comment: The greater the variability, the greater the probability of the market maker incurring a loss in excess of a stated bound between the time of buying and reselling the financial asset.

Diff: 2



8) The return that an investor will realize by holding a financial asset depends on all the ________ that the financial asset will pay its owners; this includes dividends on shares and coupon payments on bonds.

A) stock distributions

B) cash distributions

C) cash convertibility

D) liquid inventories

Answer: B

Diff: 1



9) Return ________ is a basic property of financial assets, in that it is a major determinant of their value.

A) convertibility

B) divisibility

C) predictability

D) complexity

Answer: C

Diff: 1



10) A ________ asset is one that provides options for the issuer or the investor, or both, and so represents a combination of simpler assets.

A) complex

B) taxable

C) predictable and divisible

D) liquid

Answer: A

Diff: 1



2 Principles of Pricing of Financial Assets

1) The fundamental principle of finance is that the true or correct price of an asset equals the ________ of all cash flows that the owner of the asset expects to receive during its life.

A) present value

B) future value

C) projected value

D) asset value

Answer: A

Diff: 1

Topic: 9.2 Principles of Pricing of Financial Assets

Objective: 9.7 the principles that reveal how the properties of an asset affect its value, either through the discount rate or through its expected cash flow

2) The correct price for a financial asset can be expressed as follows:

P = +++ where ________.

A) P = the price of the cash flow

B) CFt = the financial asset in year t (t = 1, ,N)

C) N = the maturity of the financial asset

D) r = the appropriate cash rate

Answer: C

Comment: The correct price for a financial asset can be expressed as follows:

P = +++ where

P = the prince of the financial asset; CFt = the cash flow in year t (t = 1, ,N); N = the maturity of the financial asset; and, r = the appropriate discount rate.

Diff: 2


Objective: 9.5 the principles of valuing complex financial assets

3) The appropriate discount rate, r, is the return that the market or the consensus of investors requires on the asset. A convenient (but approximate) expression for the appropriate discount rate is this: r = RR + IP + DP + MP + LP + EPP where ________.

A) IP= the real rate of interest, which is the reward for not consuming and for lending to other users.

B) MP = the maturity risk premium, which is the reward for taking on the risk of default in the case of a loan or bond or the risk of loss of principal for other assets.

C) LP = the liquidity premium, which is the reward for not consuming and for lending to other users.

D) EP= the exchange-rate risk premium, which is the reward for investing in an asset that is not denominated in the investor's home currency.

Answer: D

Comment: The appropriate discount rate, r, is the return that the market or the consensus of investors requires on the asset. A convenient (but approximate) expression for the appropriate discount rate is this: r = RR + IP + DP + MP + LP + EP where

RR = the real rate of interest, which is the reward for not consuming and for lending to other users;

IP = the inflation premium, which is the compensation for the expected decline in the purchasing power of the money lent to borrowers;

DP = the default risk premium, which is the reward for taking on the risk of default in the case of a loan or bond or the risk of loss of principal for other assets;

MP = the maturity premium, which is the compensation for lending money for long periods of time;

LP = the liquidity premium, which is the reward for investing in an asset that may not be readily converted to cash at a fair market value; and,

EP= the exchange-rate risk premium, which is the reward for investing in an asset that is not denominated in the investors home currency.

Diff: 2


Objective: 9.2 the components of an asset's discount rate or required rate of return

4) DP is the default risk premium, which is the ________.

A) reward for investing in an asset that may not be readily converted to cash at a fair market value.

B) reward for taking on the risk of default in the case of a loan or bond or the risk of loss of principal for other assets.

C) compensation for lending money for long periods of time.

D) reward for investing in an asset that is not denominated in the investor's home currency.

Answer: B

Comment: DP is the default risk premium, which is the reward for taking on the risk of default in the case of a loan or bond or the risk of loss of principal for other assets.

MP is the maturity premium, which is the compensation for lending money for long periods of time.

LP is the liquidity premium, which is the reward for investing in an asset that may not be readily converted to cash at a fair market value.

EP is the exchange-rate risk premium, which is the reward for investing in an asset that is not denominated in the investors home currency.

Diff: 1


Objective: 9.4 how the discount rate is structured to encompass the components of an asset's risk

5) Assume that the market thinks the real rate is 2.00%, the inflation premium is 2.70%, the bond's default risk justifies a premium of 2.10%, the maturity premium is 0.50%, and the liquidity premium is 1.10%. Since the cash flows are denominated in euros, the foreign-exchange rate premium is 1.50%. What is the discount rate?

A) 8.90%

B) 9.70%

C) 9.90%

D) None of these

Answer: C

Comment: We have: RR = 2.00%, IP = 2.70%, DP = 2.01%, MP = 0.50%, LP = 1.01%, EP = 1.50%. Thus, we have this value for the discount rate: r = 2.0% + 2.7% + 2.1% + 0.5% + 1.1% + 1.5% = 9.90% or 0.0990.

Diff: 2



6) Suppose the cash flows for a bond's coupon payment for years 1 through 4 are $100. That is, CFt = $100 for t (t = 1, ... ,4). Further assume the the discount rate is 9.00% and at the end of year the bond will pay back the bond's par value of $1,000. To the nearest dollar, what is the correct price for this bond?

A) $866

B) $932

C) $1,012

D) $1,032

Answer: D

Comment: The correct price for the bond can be expressed as follows:

P = + ... + where P = the prince of thebond; CFt = the cash flow in year t (t = 1, , N); N = the maturity of the bond; and, r = the appropriate discount rate. Inserting our given values, where CF1 = CF2 = CF3 = $100, CFN = CF4 = $1,000 + $100 = $1,100 and r = 9.00% or 0.09, we have:

P = + + + = $91.7431 + 84.168 + $77.21835 + $779.2677 = $1,032.40.

Diff: 3



7) Suppose the cash flows for a financial asset's payment for years 1 through 4 are $100. That is, CFt = $100 for t (t = 1, ... ,4). Further assume the the discount rate is 8.00% and at the end of four years that the financial asset will pay $1,000 in addition to the $100. Finally, assume a broker's commission of $30 is imposed by brokers to buy or sell the bond. To the nearest dollar, what is the correct price for this financial asset?

A) $1,014

B) $1,000

C) $994

D) None of these

Answer: A


P = +++ where P = the prince of the financial asset; CFt = the cash flow in year t (t = 1, ,4); 4 years is the maturity of the financial asset; and, r = the appropriate discount rate. For this case we must subtract $30 at the beginning (t = 0) and subtract out $30 at t = 4. Inserting our given values, where CF1 = CF2 = CF3 = $100, CF4 = $1,000 + $100 - $30 = $1,070, and r = 8.00% or 0.08, we have:

P = -$30 + +++= -$30+ $92.59259 + $85.73388 + $79.38322 + $786.4819 = $1,014.19.

Diff: 3



8) Suppose the cash flows for a financial asset's payment for years 1 through 5 are $80. That is, CFt = $80 for t (t = 1, ... ,5). Further assume the the discount rate is 8.00% and at the end of the five years that the financial asset will pay back $1,000 in addition to the $80. Finally, assume a broker's commission of $30 is imposed by brokers to buy or sell the financial asset and that a government entity imposes a transfer tax of $20 on each transaction. To the nearest dollar, what is the correct price for this financial asset?

A) $912

B) $914

C) $916

D) $918

Answer: C


P = ++++ where P = the prince of the financial asset; CFt is the cash flow in year t (t = 1, ,5); 5 years is the maturity of the financial asset; and, r is the appropriate discount rate. For this case we must subtract $30 and $20 at the beginning (t = 0) and also subtract out $30 and $20 at t = 5. Inserting our given values, where CF1 = CF2 = CF3 = CF4 =$80, CF5 = $1,000 +$80 - $30 - $20 = $1,030, and r = 8.00% or 0.08, we have:

P = -$30 -$20 + ++++ = -$30 -$20 + $74.0741 + $68.5871 + $63.5066 + $58.8024 + $701.0007 = $915.97.

Diff: 3



9) Suppose the cash flows for a financial asset's payment for years 1 through 5 are $90. That is, CFt = $90 for t (t = 1, ... ,5). Further assume the the discount rate is 7.00% and at the end of the five years that the financial asset will pay back $1,000 in addition to the $90. Finally, assume a broker's commission of $40 is imposed by brokers to buy or sell the financial asset and that a government entity imposes a transfer tax of $25 on each transaction. To the nearest dollar, what is the correct price for this financial asset?

A) $962

B) $971

C) $986

D) $1,002

Answer: B


P = ++++ where P = the prince of the financial asset; CFt is the cash flow in year t (t = 1, ,5); 5 years is the maturity of the financial asset; and, r is the appropriate discount rate. For this case we must subtract $40 and $25 at the beginning (t = 0) and also subtract out $30 and $20 at t = 5. Inserting our given values, where CF1 = CF2 = CF3 = CF4 =$90, CF5 = $1,000 +$90 - $40 - $25 = $1,025, and r = 7.00% or 0.07, we have:

P = -$40 -$25 + + + + + = -$40 -$25 + $84.1121 + $78.6095 + $73.4668 + $68.6606 + $730.8108 = $970.66.

Diff: 3



10) Suppose that a bond is granted a favorable tax treatment such that the interest and any capital gain from this bond would not be taxed. Suppose that the marginal tax rate on otherwise equivalent taxable bonds is 25% and the appropriate discount rate is 7%. What is the after-tax discount rate?

A) 5.25%

B) 5.35%

C) 5.65%

D) 5.75%

Answer: A

Comment: The after-tax discount rate is: pretax discount rate * (1 - marginal tax rate) = 0.09 * (1 - 0.25) = 0.052500 = 5.25%.

Diff: 2



11) Although we use a single discount rate to discount each cash flow, there are theoretical reasons that suggest this is ________.

A) not practical.

B) always correct but not practical.

C) suitable.

D) inappropriate.

Answer: D

Diff: 1



12) The appropriate ________ can often be approximated as the sum of rewards for the various risks an asset poses to its buyer.

A) reward premium

B) discount rate

C) risk premium

D) coupon rate

Answer: B

Diff: 2



3 Price Volatility of Financial Assets

1) A fundamental principle is that a financial asset's price changes in ________.

A) the same direction of the change in the required rate of return.

B) the same direction of the change in the required yield.

C) unknown and unpredictable ways compared to the change in the required yield.

D) the opposite direction of the change in the required rate of return or the required yield.

Answer: D

Diff: 1

Topic: 9.3 Price Volatility of Financial Assets

Objective: 9.6 the inverse relationship between an asset's price and its discount rate

2) The ________ of a financial asset to a change in the required yield will not be the same for all assets.

A) price indifference

B) price insensitivity

C) price sensitivity

D) cash flow sensitivity

Answer: C

Diff: 2


Objective: 9.8 what factors affect the price sensitivity of a financial asset to changes in interest rates

3) When we refer to changes in the required yield, it is convenient to measure a change in yield in terms of what market participants refer to as ________.

A) a basis modification rather than a yield modification.

B) a yield modification rather than in terms of a basis modification.

C) a percentage change rather than a basis point.

D) a basis point rather than in terms of a percentage change.

Answer: D

Comment: When we refer to changes in the required yield, it is convenient to measure a change in yield in terms of what market participants refer to as a basis point rather than in terms of a percentage change.

Diff: 2


Objective: 9.3 what is meant by a basis point

4) Which of the below statements is TRUE?

A) Fifty basis points are equal to one-fifth percentage point, and a yield change from 9% to 9.2% represents a 50 basis point change in yield.

B) One basis point is defined as 0.0001, or equivalently, 0.01%.

C) A yield change from 7% to 7.5% is a 0.50 basis point change.

D) A yield change from 6% to 8.35% is a 2,350 basis point change in yield.

Answer: B

Comment: One basis point is defined as 0.0001, or equivalently, 0.01%. Therefore, 100 basis points are equal to one percentage point, and a yield change from 9% to 10% represents a 100 basis point change in yield. A yield change from 7% to 7.5% is a 50 basis point change, and a yield change from 6% to 8.35% is a 235 basis point change in yield.

Diff: 2


Objective: 9.3 what is meant by a basis point

5) For two bonds with the same maturity and with the same required yield, the lower the coupon rate, the greater the price responsiveness for a given change in the required yield. This is an example of ________ affecting a bond's price sensitivity.

A) a bond's maturity

B) a bond's coupon rate

C) a bond's principal

D) a change in Fed policy

Answer: B

Diff: 2



6) This measure of price sensitivity is popularly referred to as ________.

A) basis point sensitivity.

B) value sentiment.

C) duration.

D) saturation.

Answer: C

Diff: 1


Objective: 9.9 what duration means, and how it is related to the price sensitivity of an asset to a change in interest rates

7) Approximate percentage change in a financial asset's price equals what?

A) It equals -Duration x (Yield change in decimal forms) x 100.

B) It equals [-Duration / (Yield change in decimal forms)] x 100.

C) It equals -Duration x [(Yield change in decimal forms) / 100].

D) It equals +Duration x (Yield change in decimal forms) x 100.

Answer: A

Diff: 2



8) Suppose that the required yield on a 6% coupon, 12-year bond increases from 10% to 11% (0.01 in decimal form). If this bond's duration is 8.96, what is the approximate percentage change in price?

A) -4.48%

B) +7.48%

C) -8.96%

D) +9.86%

Answer: C

Comment: The approximate percentage change in a financial assets price = -Duration * (Yield change in decimal forms) * 100. Inserting in our values, we get: approximate percentage change in price =-8.96 x (0.01) x 100 =-8.96%.

Diff: 2



9) Assume the price of a coupon bond is $650. Further assume that if the yield is increased by 50 basis points, then the price would be $620 and if the yield is decreased by 50 basis points, then the price would be $700. What is the duration?

A) about 12.3

B) about 12.8

C) about 13.3

D) about 13.6

Answer: A

Comment: We have these values: y = 0.005, P0 = $650, P_ = $700, and P+= $620. The duration (or approximate percentage price change for a 100 basis point change in yield) is . Inserting in our values, we get: = 12.31.

Diff: 2



10) Which of the below statements is FALSE?

A) The importance of being able to measure the sensitivity of an individual asset, a portfolio of assets, and a liability cannot be overemphasized.

B) To control interest rate risk, it is necessary to be able to measure it.

C) An investor with a portfolio of assets wants to be able to measure her exposure to interest rate changes in order to assess whether or not the exposure is acceptable. If it is not, she can alter the exposure.

D) When a duration is calculated under the assumption that the cash flows do not change when interest rates change, the resulting duration is called effective duration.

Answer: D

Comment: When a duration is calculated under the assumption that the cash flows do not change when interest rates change, the resulting duration is called modified duration. In contrast, a duration calculated assuming that the cash flow changes when interest rates change is called effective duration. The difference between modified duration and effective duration for some assets can be quite dramatic.

Diff: 2



True/False Questions


1) A useful way to think of liquidity and illiquidity, proposed by Professor James Tobin, is in terms of how much sellers stand to lose if they wish to sell immediately as against engaging in a costly and time-consuming search.

Answer: TRUE

Diff: 1



2) Tax rates are constant from year to year, from country to country, and even among municipal units within a country (as with state and local taxes in the United States).

Answer: FALSE

Comment: Tax rates differ from year to year, from country to country, and even among municipal units within a country (as with state and local taxes in the United States).

Diff: 1



3) A financial asset has many properties, and each affects the asset's value in a similar and important way.

Answer: FALSE

Comment: A financial asset has many properties, and each affects the assets value in a distinctive and important way.

Diff: 1



4) Some properties are intrinsic to the asset, such as its maturity or promised cash flow.

Answer: TRUE

Diff: 1




1) The price of a complex asset is the sum of the prices of its component parts.

Answer: TRUE

Diff: 1



2) The price of an asset moves in the same direction of a change in its discount rate.

Answer: FALSE

Comment: The price of an asset moves in the opposite direction of a change in its discount rate.

Diff: 1


Objective: 9.6 the inverse relationship between an asset's price and its discount rate

3) An asset's price is the present value of its expected cash flows, discounted at an appropriate rate.

Answer: TRUE

Diff: 1



4) The conversion privilege of a convertible bond is not valued by the market.

Answer: FALSE

Comment: The conversion privilege of a convertible bond is valued by the market .

Diff: 1




1) The term duration was first used in 1938 by Frederick Macaulay as a measure of the weighted average time to maturity of a bond.

Answer: TRUE

Diff: 1



2) It is important to be able to measure the price sensitivity of an asset or liability to interest rate changes and the appropriate measure is the modified duration.

Answer: FALSE

Comment: It is important to be able to measure the price sensitivity of an asset or liability to interest rate changes and the appropriate measure is the effective duration.

Diff: 1



3) The larger an asset's coupon rate, the greater its price sensitivity to a change in the discount rate, other things being constant.

Answer: FALSE

Comment: The longer an assets maturity, the greater its price sensitivity to a change in the discount rate, other things being constant.

The larger an assets coupon rate, the lower its price sensitivity to a change in the discount rate, if all else is the same.

Diff: 2



4) Factors that influence an asset's price sensitivity include its maturity, its coupon rate, and the initial level of the required yield.

Answer: TRUE

Diff: 1



Essay Questions


1) It should be understood that even a financial asset with a stated maturity may terminate before its stated maturity. This may occur for several reasons. Describe some of these reasons.

Answer: Reasons for the termination of a financial asset include bankruptcy or reorganization. In addition, a financial asset (like a bond) may have a call provisions entitling the debtor to repay in advance, usually at some penalty and only after a number of years from the time of issuance. Sometimes the investor may have the privilege of asking for early repayment. This feature is called a put option. Some assets have maturities that may be increased or extended at the discretion of the issuer or the investor. For example, the French government issues a six-year obligation renouvelable du Trsor, which allows the investor, after the end of the third year, to switch into a new six-year debt. Similar bonds are issued by the British government.

Diff: 3



2) For financial assets traded with market makers, the most relevant component of round-trip cost is the bid-ask spread. The spread charged by a market maker varies sharply from one financial asset to another, reflecting primarily the amount of risk the market maker is assuming by "making" a market. This market-making risk can be related to two main forces. Describe these two forces or determinants of this risk.

Answer: One force is the variability of the price as measured, say, by some measure of dispersion of the relative price over time. The greater the variability, the greater the probability of the market maker incurring a loss in excess of a stated bound between the time of buying and reselling the financial asset. The variability of prices differs widely across financial assets. Treasury bills, for example, have a very stable price, while a speculative stock will exhibit much larger short-run variations.

The second determining factor of the bidask spread charged by a market maker is what is commonly referred to as the thickness of the market: by this is meant essentially the prevailing rate at which buying and selling orders reach the market maker (that is, the frequency of transactions). A thin market is one that has few trades on a regular or continuing basis. Clearly, the greater the frequency of order flows, the shorter the time that the security will have to be held in the market maker's inventory, and hence the smaller the probability of an unfavorable price movement while held.

Diff: 3




1) Suppose that you have a bond issued by a German firm and that all payments are in euros for the maturity of the bond which is four years. Why is the cash flow in U.S. dollars that you will receive as a U.S. investor uncertain? In your answer illustrate the uncertainty in terms of an exchange rate premium and the appropriate discount rate.

Answer: The cash flow in U.S. dollars that a U.S. investor will receive is uncertain because the dollar-euro exchange rate will fluctuate over the four years. Suppose that the market assigns an exchange premium of 3%. This means that the appropriate discount rate increases from 9% to 12%. To continue with the effect of currency risk, suppose that immediately after the purchase of this bond the market expects that the exchange rate between the U.S. dollar and the euro will become more volatile. The market will adjust for this by increasing the foreign currency risk premium, which, in turn, increases the appropriate discount rate and decreases the price.

Diff: 3



2) Define what we mean by "an appropriate discount rate". Describe four of the six components that make up this rate.

Answer: The appropriate discount rate, r, is the return that the market or the consensus of investors requires on the asset. A convenient (but approximate) expression for the appropriate discount rate can be expressed in terms of six components. This is shown below:

r = RR + IP + DP + MP + LP + EP where

RR = the real rate of interest, which is the reward for not consuming and for lending to other users

IP = the inflation premium, which is the compensation for the expected decline in the purchasing power of the money lent to borrowers

DP = the default risk premium, which is the reward for taking on the risk of default in the case of a loan or bond or the risk of loss of principal for other assets

MP = the maturity premium, which is the compensation for lending money for long periods of time

LP = the liquidity premium, which is the reward for investing in an asset that may not be readily converted to cash at a fair market value

EP= the exchange-rate risk premium, which is the reward for investing in an asset that is not denominated in the investor's home currency.

Diff: 3




1) An asset's maturity is a factor that affects its price sensitivity to a change in yield. In fact, a bond's price sensitivity to a change in the discount rate is positively related to the bond's maturity. Consider the case of two bonds that have the same coupon rate, and the same required yield but different maturities. If the required rate were to change, the price sensitivity of the bond with the longer maturity would be greater than that of the bond with the shorter maturity. Give an illustration of this.

Answer: An illustration of this link between maturity and price change appears in Table 9-2, which shows the price of a bond that pays $50 annually and $1,000 at maturitya 5% coupon ratefor various maturities and discount rates. Table 9-3, which is based on Table 9-2, shows the differences across maturities in a bond's dollar price decline and percentage price decline for an increase in the discount rate of 100 basis points. For example, if the discount rate rises from 9% to 10%, the price of a four-year bond falls from $870.41 to $841.51, which represents a price decline of $28.90 and a percentage price decline of 3.32%. In contrast, a similar rise in the discount rate causes the price of a 20-year bond to fall considerably more, from $634.86 to $574.32, which represents a price decline of $60.54 and a percentage price decline of 9.54%.

Diff: 3



2) Explain the difference between modified duration and effective duration. In your also give an example of when the difference can be dramatic.

Answer: When a duration is calculated under the assumption that the cash flows do not change when interest rates change, the resulting duration is called modified duration. In contrast, a duration calculated assuming that the cash flow changes when interest rates change is called effective duration. The difference between modified duration and effective duration for some assets can be quite dramatic. For example, with some of the more complex financial instruments, the modified duration could be four while the effective duration could be 25. This means that an investor might believe that the price of the asset will change by approximately 4% for a 100 basis point change in interest rates (modified duration) when, in fact, it would change by approximately 25% for a 100 basis point change in interest rates (effective duration).

Diff: 3



1Copyright 2010 Pearson Education Inc. Publishing as Prentice Hall

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fabozzi_chapter09

Documents

return predictability

liquidity c liquidity

cash flow d money

tax status b convertibility

moneyness divisibility

denomination answer

risk complexity

near money