Which of the following statements is NOT CORRECT? A. Other things being equal, t
ID: 1169935 • Letter: W
Question
Which of the following statements is NOT CORRECT? A. Other things being equal, the longer the time to maturity, the greater the change in the value of a bond in response to a given change in interest rates. B. You hold a 5-year zero coupon bond and a 5-year bond that has a 6% annual coupon. The same market rate, 10%, applies to both bonds. If the market rate increases from the current level, the zero coupon bond will experience a larger percentage increase in price. C. The time to maturity affects the change in the value of a bond in response to a given change in interest rates. D. You hold a 10-year zero coupon bond and a 10-year bond that has a 6% annual coupon. The same market rate, 6%, applies to both bonds. If the market rate rises from the current level, the zero coupon bond will experience a larger percentage decline in price. E. You hold a 10-year zero coupon bond and a 10-year bond that has a 6% annual coupon. The same market rate, 6%, applies to both bonds. If the market rate drops from the current level, the zero coupon bond will experience a larger percentage increase in price. Which of the following statements is NOT CORRECT? A. Other things being equal, the longer the time to maturity, the greater the change in the value of a bond in response to a given change in interest rates. B. You hold a 5-year zero coupon bond and a 5-year bond that has a 6% annual coupon. The same market rate, 10%, applies to both bonds. If the market rate increases from the current level, the zero coupon bond will experience a larger percentage increase in price. C. The time to maturity affects the change in the value of a bond in response to a given change in interest rates. D. You hold a 10-year zero coupon bond and a 10-year bond that has a 6% annual coupon. The same market rate, 6%, applies to both bonds. If the market rate rises from the current level, the zero coupon bond will experience a larger percentage decline in price. E. You hold a 10-year zero coupon bond and a 10-year bond that has a 6% annual coupon. The same market rate, 6%, applies to both bonds. If the market rate drops from the current level, the zero coupon bond will experience a larger percentage increase in price.Explanation / Answer
The sensitivity of a bond's price to a change in its interest rate is usually measured (actually approximated) by the bond's duration. Greater the bond duration greater is the bond's price sensitivity to changes in interest rates. Bond Duration is directly proportional to the time to maturity of a bond, thereby implying that longer tenure bonds will have greater durations and hence greater sensitivity to a given change in interest rates. Further, zero coupon bonds have durations equal to their maturity and hence any coupon-bearing bond with an equal interest rate and maturity as that of the zero coupon bond will have a duration lesser than the zero coupon bond (as coupon-bearing bonds have duration lesser than their maturity).
In light of the above information, statement (A), (D) and (E) are correct. Statement (C) is correct because a bond's maturity indeed impacts its price change upon a given interest rate change with longer maturity bonds undergoing a greater price change for the same interest rate change as compared to a lower maturity bond.
The incorrect statement is (B) as an increase in interest rate would decrease the bond's price(and not increase as mentioned in the statement). This is because bond price and interest rates are inversely related.
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