Question

Spice asks Meyers (see the previous problem below) to quantify price changes from changes in interest rates. To illustrate, Meyers computes the value change for the fixed-rate note in the table. He assumes an increase in the interest rate level of 100 basis points. Using the information in the table, what is the predicted change in the price of the fixed-rate note?

Frank Meyers, CFA, is a fixed-income portfolio manager for a large pension fund. A member of the Investment Committee, Fred Spice, is very interested in learning about the management of fixed-income portfolios. Spice has approached Meyers with several questions. Specifically, Spice would like to know how fixed-income managers position portfolios to capitalize on their expectations of future interest rates.

Meyers decides to illustrate fixed-income trading strategies to Spice using a fixed rate bond and note. Both bonds have semi-annual coupon periods. All interest rate (yield curve) changes are parallel unless otherwise stated. The characteristics of these securities are shown in the following table. He also considers a nine-year floating-rate bond (floater) that pays a floating rate semi-annually and is currently yielding 5%.

Spice asks Meyers about how a fixed-income manager would position his portfolio to capitalize on expectations of increasing interest rates. Which of the following would be the most appropriate strategy?

a. Shorten his portfolio duration.

b. Buy fixed-rate bonds.

c. Lengthen his portfolio duration.

Short answer

Answer

Decrease in bond price by $3.59

Step-by-step solution

Step by Step Solution Step 1: Given information

Effective duration = 3.5851

Change in interest rate = 0.01

Calculation of predicted change in price

Since Duration fixed Rate note = Effective duration x Price x Change in interest rate

= 3.5851 x 100.000 x 0.01

= 3.5851

This implies an increase in interest rate hence the decrease in bond value by $3.59