Question

Q1-7. Which of the following statements are TRUE about coupon bonds?
I. If there are two par bonds with the same coupon, market price and principal but with different maturity, the one with longer maturity should have higher duration.
II. A junk bond (or deep discount bond) must pay high coupon in general as it contains high level of risk.
III. If an investor tries to avoid reinvestment rate risk as much as possible, he/she should go for low coupon bonds instead of high coupon bonds.
IV. If you hold a premium bond, it is always better for you to sell it before the maturity as the bond prices will go down throughout its lifespan.

A. I and II only
B. I and III only
C. II and III only
D. I and IV only
E. I, II and IV only

Q1-8. A market maker wants to delta hedge a long position of $10 million in face value of 20-year bonds with 30-year bonds until he/she finds a buyer of the 20-year bonds. DV01 of the 20-year bond is 0.1184 and DV01 of the 30-year bond is 0.1429. If the 20-year yield is expected to rise 1.1bp for each 1bp increase in the 30-year bond, what should be the position of the 30-year bond for this market maker?

A. Short position of $13.28 million
B. Long position of 13.28 million
C. Short position of 10.97 million
D. Short position of 9.11 million
E. Short position of 7.53 million

Answer 1

The Correct option is:

C. II and III only

• Junk bonds are generally speculative in nature and come under high risk and high yield bonds class. The coupon rate of interest is high on these bonds as comparison to other typeof bonds. However, the interest risk and principle risk of these bonds are also higher.
• Reinvestment risk refers to the possibility that an investor will be unable to reinvest cash flows (e.g., coupon payments) at a rate comparable to their current rate of return. Therefore an investor should go for lower coupon bonds as it has lower risks compared to higher coupon bonds.