Question

You own a bond that has a duration of 7 years. Interest rates are currently 8%, but you believe the Fed is about to increase interest rates by 23 basis points. Your predicted price change on this bond is

Answer 1

Step 1: Calculation of Yield To Maturity(YTM)

In this case

Interest rate = Yield To Maturity = 8%

Step 2: Calculation of Modified Duration

Modified Duration = Duration / (1+Yield to maturity)

= 7 / 1.08

= 6.48 years

Step 3: Calculation of price change

We know, 1 basis points = 1/100% or .01%. Hence 23 basis points = 23/100 = .23%

Also, modified duration measures the percent change in market price for every percent change in YTM(here interest rate=YTM). The direction of change are in opposite direction.

percent change in price = modified duration * percent change in YTM

= 6.48*.23%

= 1.4904%