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CFA Level I · CFA Level I Exam · Interest Rate Risk and Return

Two option-free bonds have the same modified duration and yield. Bond X has higher convexity than Bond Y. An analyst expecting a large, uncertain change in interest rates would most likely prefer Bond X because, for a given yield change, it has:

Bond X has a more favorable price response in both directions. With equal duration, its larger convexity adds a bigger positive term to the price change, so it gains more when yields fall and loses less when yields rise, especially for large yield moves.

  1. Aa lower price volatility in both directions
  2. Ba more favorable price response than Bond Y in both directionsCorrect
  3. Ca larger price decline than Bond Y when yields rise

Explanation

With equal duration, the higher-convexity bond gains more when yields fall and loses less when yields rise, since the convexity term 0.5 x C x (Δy)^2 is always positive and larger for X. The advantage grows with the size of the yield change.

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