Question

You are evaluating two bond to purchase. Bond A is a corporate bond with a modified duration of 7 years and YTM of 5%. Bond B is also a corporate bond with the same credit rating. It has a modified duration of 5 years with YTM of 4.6%.

1. Explain the concept of duration.

2. Calculate the potential price change for bond A if rate goes up by .50%

3. Calculate the potential price change for bond B if rate goes up by .50%

4.You are concerned that interest rate will go up, which bond you would likely purchase?

Answer 1

Duration is a measure of the sensitivity of the price of a bond or other debt instrument to a change in interest rates.

it is given by the formula

where CF = cash flow

t = corresponding period of cash flow

i = yield

N = time to maturity

V_b = bond price

2

percentage change in bond price= -duration *change in yield

= -7*0.5 = -3.5%

3

percentage change in bond price= -duration *change in yield

= -5*0.5 = -2.5%

4

Purchase Bond B as it has smaller duration, so its price will fall lesser compared to bond A when the yield goes up