A bond with a 5% coupon trades at 95. An increase in interest rates by 10 bps causes its price to decline to $94.50. A decrease in interest rates by 10 bps causes its price to increase to $95.60. Estimate the modified duration of the bond.

A bond with a 5% coupon trades at 95. An increase in interest rates by 10 bps causes its price to decline to $94.50. A decrease in interest rates by 10 bps causes its price to increase to $95.60. Estimate the modified duration of the bond.
A . 5
B . 5.79
C . 5.5
D . -5

View Answer

Answer: B

Explanation:

In this case, we can estimate the duration of the bond as follows: we know that a 10 bps increase in rates causes the price to move to $94.50, and a 10 bps decrease causes the price to increase to $95.60. Thus, over the range of the 20 bps, the average change in price per basis point is ($95.60 – $94.50)/20 bps = $1.10/20 = $0.055/basis point, or $0.055* 100 = $5.5 for 100 basis points (ie 1%). We know that modified duration is equivalent to the percentage change in the bond price as a result of a 1% change in interest rates. A 1% change in the interest rates leading to a $5.5 change in a bond priced at $95 equates to $5.5/$95 = 5.79%, in other words the modified duration is roughly equal to 5.79 years.

In fact if we know the price of a bond at any two different interest rates, we can make an estimate of modified duration. Modified duration is just the first derivative with respect to price, and given two prices and the associated yields, we can easily calculate modified duration to be the ratio of the change in price to the change in interest rates. In this question, we are given both an up move and a down move. Using this estimation, only one data point (ie, either the up price or the down price) in addition to the starting point ($95) would have been enough to come to a rough estimate of modified duration. You will notice that the modified duration would be slightly different if we were to use the high point and the starting point (ie $95.60 and $95), and the starting point and the lower point ($95 and $94.50). The difference is due to convexity. The decrease in price is lower than the increase in price – and this is due to the convexity of the bond.