Question

Cardinal Mania is issuing bonds with the following annual coupon rates, maturities, and face values:

- Bond A: 6%, 10 years, 1000;

- Bond B: 8%, 15 years, 2000;

- Bond C: 6%, 5 years, 500;

Assuming that all market interest rates are constant at 2%, order the price sensitivity of these bonds from large to small.

Answer 1

Duration is a measure of the sensitivity of the price of a bond to a change in interest rates. It accelerates as time to maturity is reduced

Duration measures how long it takes for an investor to be repaid the bond’s price by the bond’s total cash flows in number of years.

Hence,

• Higher the time to maturity, higher the duration, and the greater the interest rate risk
• Lower the Coupon rate,  higher the duration, and the lhigher the interest rate risk

In above example, following is the sequence of bonds having higher price sensitivity i.e. large to small sequence

1) Bond B: 8%, 15 years, 2000; - Highest since time to maturity is 20 years

2) Bond A: 6%, 10 years, 1000;- 2nd since same coupon as Bond C and higher time to maturity compared to Bond C

3) Bond C: 6%, 5 years, 500;- 3rd since lowest time to maturity and same coupon rate as bond A