Question

Suppose a recently published report indicates inflation in both Canada and the U.S. is becoming excessive and the Canadian dollar is weakening. You hear a news report that the bond prices are falling. Which of the following Canadian bonds would experience the lowest % price decrease? Why?

Low coupon, short-term

High coupon, long-term

High coupon, short-term

Low coupon, long-term

Answer 1

Typically price sensitivity to interest rate changes are measured by a metric known as Convexity. Those bonds having longer marturity and smaller coupons will experience larger convexity or larger % price changes. In other words, bonds with short term maturities and high coupon experience lowest % price changes.Convexity can be defined as the sensitivity of bond's duration to changes in interest rates. One reason for short term maturity bond exhibiting lowest price changes is low default risk . Similar is the case for high coupon bonds.

Answer is High coupon, Short-term