CFA Practice Question

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CFA Practice Question

Which of the following statements is (are) true with respect to the usage of the various forms of duration and convexity measures?

I. Holding everything constant, modified duration will always be higher than Macaulay duration.
II. Both modified duration and Macaulay duration assume that the cash flows from a bond will not be affected by changes in interest rates.
III. If interest rates are low enough, effective duration and modified duration will yield the same results for a callable bond.
IV. When there is increasing likelihood that the issuer will call the bonds, effective convexity, as opposed to modified convexity, should be used.
A. II and IV
B. I and II
C. III and IV
Explanation: I is incorrect because modified duration is simply Macaulay duration divided by one plus the periodic yield. Since Macaulay duration is being divided by a factor greater than one, the modified duration will be less than the Macaulay duration.

III is incorrect because if interest rates are low enough, the issuer may actually call the bonds. Thus, effective duration, which takes into account embedded options, will produce results that are very different from those of modified duration.

User Contributed Comments 3

User Comment
aggabad if interest are very low it is very likely that a callable bond will be called
luccky why c is wrong
Jurrens luccky: it says for a "callable" bond, which callable bonds are more likely to be called with low rates, and effective duration factors this in
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