Baran

 

14、Which of the following bonds may have negative convexity:

A) Mortgage backed securities.  

B) High yield bonds. 

C) Callable bonds. 

D) All of these choices are correct.

Baran

 

The correct answer is D

 

Negative convexity is the idea that as interest rates decrease they get to a certain point where the value of certain bonds (bonds with negative convexity) will start to increase in value at a decreasing rate.  

Interest rate risk is the risk of having to reinvest at rates that are lower than what an investor is currently receiving.

Mortgage backed securities (MBS) may have negative convexity because when interest rates fall mortgage owners will refinance for lower rates, thus prepaying the outstanding principal and increasing the interest rate risk that investors of MBS may incur.

Callable bonds are similar to MBS because of the possibility that the principal is being returned to the investor sooner than expected if the bond is called causing a higher level of interest rate risk.

High yield bonds may exhibit negative convexity because they are lower quality bonds with large coupon payments thus causing a larger potential for interest rate risk when interest rates fall because the investor has to reinvest their cash flows at a lower interest rate which is similar to both MBS and callable bonds.  High yield issuers would be more prone to refinancing their debt as interest rates fall since they pay an initially high rate of interest and would greatly benefit by refinancing.

Baran

 

15、Which of the following statements best describes the concept of negative convexity in bond prices? As interest rates:

A) fall, the bond's price increases at an increasing rate.

B) rise, the bond's price approaches a minimum value.  

C) fall, the bond's price increases at a decreasing rate. 

D) rise, the bond's price decreases at a decreasing rate.

Baran

 

The correct answer is C

 

Negative convexity occurs with bonds that have prepayment/call features. As interest rates fall, the borrower/issuer is more likely to repay/call the bond, which causes the bond’s price to approach a maximum. As such, the bond’s price increases at a decreasing rate as interest rates decrease.

Baran

 

16、Negative convexity for a callable bond is most likely to be important when the:

A) bond is first issued.  

B) price of the bond approaches the call price. 

C) S& or Moody's rating on the bond falls.  

D) market interest rate rises above the bond's coupon rate. 

Baran

 

The correct answer is B

 

Negative convexity illustrates how the relationship between the price of a bond and market yields changes as the bond price rises and approaches the call price. The convex curve that we generally see for non-callable bonds bends backward to become concave (i.e., exhibit negative convexity) as the bond approaches the call price.

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