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CFA Level I · CFA Level I Exam · Curve-Based and Empirical Fixed-Income Risk Measures

Effective convexity, rather than approximate convexity based on yield-to-maturity changes, is most appropriate for a bond with an embedded option because:

Effective convexity is most appropriate because the embedded option changes the bond's expected cash flows when the benchmark curve shifts. Curve-based revaluation captures that change, whereas yield-to-maturity based measures assume cash flows are fixed and so misstate the price sensitivity of option bonds.

  1. Athe bond's yield-to-maturity is always lower than the benchmark yield
  2. Bthe option changes expected cash flows when the benchmark curve shiftsCorrect
  3. Ceffective convexity ignores the volatility of future interest rates

Explanation

Effective measures revalue the bond using a shifted benchmark curve, allowing the cash flows to change as the option is exercised or not. Yield-based measures assume fixed cash flows, which is invalid when an option exists.

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