CFA Level II ExamFixed IncomeHard
A fixed-income analyst is comparing two bonds, Bond X and Bond Y, both with a 5-year maturity and a 4% annual coupon rate. Bond X is a straight (option-free) bond, while Bond Y is a callable bond with a call price of $1,020, callable annually starting from Year 1. Assuming all other factors are equal, which of the following statements about their effective duration is most accurate if interest rates are expected to fall significantly?
- ABond X will have a lower effective duration than Bond Y.
- BBoth bonds will have similar effective durations.
- CBond Y will have a lower effective duration than Bond X.
- DThe effective duration of Bond Y will be negative.
Show answer & explanationAnswer & explanation
Correct answer: C. Bond Y will have a lower effective duration than Bond X.
If interest rates are expected to fall significantly, the callable bond (Bond Y) is more likely to be called by the issuer. This call feature effectively shortens the bond's expected life and limits its potential price appreciation, making its price less sensitive to further decreases in interest rates. Consequently, Bond Y's effective duration will be lower than that of the option-free Bond X.
Why the other options are wrong
- A. Bond X, being option-free, will have a higher effective duration than the callable Bond Y when interest rates are expected to fall.
- B. The embedded call option creates a significant difference in their effective durations, especially when rates are expected to fall.
- D. Effective duration is typically positive; negative effective duration is extremely rare and usually only occurs in very specific, complex structured products, not standard callable bonds.
Effective Duration of Callable Bonds
Effective duration measures the interest rate sensitivity of bonds with embedded options, accounting for how changes in interest rates affect the option's value and thus the bond's cash flows.
- Callable bonds have lower effective duration than comparable option-free bonds when rates fall.
- Call option limits upside price potential.
- Effective duration can change significantly with interest rate levels.
Memory trick: Call limits upside, shortens duration.