Question

Consider the following statements: Statement 1 : At yield levels close to the bond's coupon rate, an investor in a callable bond has more to gain from a decrease in yields than she has to lose from an increase in yields. Statement 2: The larger the change in yields the more inaccurate the price estimate based on duration alone and the Iower the convexity adjustment. Which of the following is most likely? A. Both Statements are incorrect B_ Only Statement 1 is correct C. Only Statement 2 is correct

Answer 1

If interest rates decrease, the bondholder would expect to pay more than $10,000 for the bond. If interest rates increase, the bondholder would expect to pay less than $10,000 for the bond. So the correct answer is option B

Step-by-step explanation:

The answer to the question depends on the direction of the change in interest rates. If interest rates decrease, the bondholder would expect to pay more than $10,000 for the bond. This is because when interest rates decrease, the existing bonds with higher coupon rates become more valuable and are priced higher than their face value.

On the other hand, if interest rates increase, the bondholder would expect to pay less than $10,000 for the bond. This is because when interest rates increase, the existing bonds with lower coupon rates become less valuable and are priced lower than their face value.

So, the statement 1 is correct, and the answer is B - Only Statement 1 is correct.