Question

The following data is available for the following bonds. The modified duration of Bond A = 10 The modified duration of Bond B = 10.5 The interest rate is likely to increase by 50 basis points. Calculate the expected change in price of these bonds and recommend which bond will be more suitable for risk averse investors.

Answer 1

Expected change in price of a Bond = Modified duration of bond × change in interest rate

For bond A, expected change in price = 10 × 0.005 = 0.0500

Thus price of bond A drops by 5% if interest rate increases by 50 basis points.

For bond B, expected change in price = 10.5 × 0.005 = 0.0525

Thus price of bond B drops by 5.25% if interest rate increases by 50 basis points.

Therefore, bond A has a lower modified duration and is more suitable for risk averse investors.