Baran

 

The correct answer is D

 

Negative convexity is the idea that as interest rates decrease they get to a certain point where the value of certain bonds (bonds with negative convexity) will start to increase in value at a decreasing rate.  

Interest rate risk is the risk of having to reinvest at rates that are lower than what an investor is currently receiving.

Mortgage backed securities (MBS) may have negative convexity because when interest rates fall mortgage owners will refinance for lower rates, thus prepaying the outstanding principal and increasing the interest rate risk that investors of MBS may incur.

Callable bonds are similar to MBS because of the possibility that the principal is being returned to the investor sooner than expected if the bond is called causing a higher level of interest rate risk.

High yield bonds may exhibit negative convexity because they are lower quality bonds with large coupon payments thus causing a larger potential for interest rate risk when interest rates fall because the investor has to reinvest their cash flows at a lower interest rate which is similar to both MBS and callable bonds.  High yield issuers would be more prone to refinancing their debt as interest rates fall since they pay an initially high rate of interest and would greatly benefit by refinancing.

Baran

 

10、How does the price-yield relationship for a callable bond compare to the same relationship for an option-free bond? The price-yield relationship is:

A) concave for low yields for the callable bond and always convex for the option-free bond.

B) the same for both bond types.

C) concave for an option-free bond and convex for a callable bond.  

D) concave for the callable bond and convex for an option-free bond. 

Baran

 

The correct answer is A

 

Since the issuer of a callable bond has an incentive to call the bond when interest rates are very low in order to get cheaper financing, this puts an upper limit on the bond price for low interest rates and thus introduces the concave relationship between yields and prices.

Baran

 

11、How does the price-yield relationship for a putable bond compare to the same relationship for an option-free bond? The price-yield relationship is:

A) more convex at some yields for the putable bond than for the option-free bond.

B) the same for both bond types.

C) more convex for a putable bond than for an option-free bond.  

D) concave for an option-free bond and convex for a putable bond.

Baran

 

The correct answer is A

 

Since the holder of a putable has an incentive to exercise his put option if yields are high and the bond price is depressed, this puts a lower limit on the price of the bond when interest rates are high. The lower limit introduces a higher convexity of the putable bond compared to an option-free bond when yields are high.

Baran

 

12、Can a fixed income security have a negative convexity?

A) No.  

B) Yes. 

C) Need more information to answer question.

D) Yes, but only when the price yield curve is linear.

Baran

 

8、The convexity of a U.S Treasury bond is usually:

A) negative.

B) zero.

C) additional information is required.

D) positive.

Baran

 

The correct answer is D

 

One characteristic of all noncallable bonds is that they have positive convexity and U.S. Treasury bonds are noncallable bonds.

Baran

 

9、Which of the following is most accurate about a bond with positive convexity?

A) Price increases when yields drop are greater than price decreases when yields rise by the same amount.

B) Positive changes in yield lead to positive changes in price.

C) Price changes are the same for both increases and decreases in yields.

D) Price increases and decreases at a faster rate than the change in yield.

Baran

 

The correct answer is A

 

A convex price/yield graph has a larger increase in price as yield decreases than the decrease in price when yields increase.  This comes from the definition of a convex graph.