Question

a. Which set of conditions will result in a bond with the greatest price volatility?

(1) A high coupon and short maturity.

(2) A high coupon and a long maturity.

(3) A low coupon and a short maturity.

(4) A low coupon and a long maturity.

b. An investor who expects declining interest rates would be likely to purchase a bond that has a _____________ coupon and a _____________ term to maturity.

(1) Low, long

(2) High, short

(3) High, long

(4) Zero, long

c. With a zero-coupon bond:

(1) Duration equals the weighted-average term to maturity.

(2) Term to maturity equals duration.

(3) Weighted-average term to maturity equals the term to maturity.

(4) All of the above.

d. As compared with bonds selling at par, deep discount bonds will have:

(1) Greater reinvestment risk.

(2) Greater price volatility.

(3) Less call protection.

(4) None of the above.

Short answer

a. 4

b. 4

c. 4

d. 2

Step-by-step solution

Explanation on the choice of conditions ‘a’

A low coupon but with a long maturity will lead to the greatest price volatility. Hence option 4 is the correct choice.

Explanation on the choice of conditions ‘b’

In the event of a likely declining interest rate, an investor should buy a zero-coupon with a long-term to maturity. Hence option 4 should be the correct choice.

Explanation on the choice of features of zero-coupon bond ‘c’

A zero-coupon bond has a duration that equals the weighted-average term to maturity, the Term to maturity equals duration and the Weighted-average term to maturity equals the term to maturity. Hence option 4, i.e. All of the above should be the correct choice.

Explanation of features of deep discount bonds ‘d’

Deep discount bonds usually have greater price volatility, when compared with bonds selling at par. Hence option 2 should be the correct option.