What Will Happen to Your Bond Investment if Interest Rates Increase?

Question:

You own a bond that has a duration of 7 years. Interest rates are currently 8%, but you believe the Fed is about to increase interest rates by 28 basis points. Your predicted price change on this bond is ________.

a. +1.81%

b. +6.48%

c. −6.48%

d. −1.81%

Answer:

The correct answer is C. −6.48%

To understand why the predicted price change on the bond would be -6.48% if interest rates increase by 28 basis points, it's important to consider the concept of bond duration. Bond duration is a measure of how sensitive a bond's price is to changes in interest rates. In simple terms, the longer the duration of a bond, the more its price will change in response to interest rate movements.

In this scenario, the bond has a duration of 7 years. When interest rates increase by 28 basis points, the expected price change can be calculated by multiplying the duration of the bond by the change in interest rates. In this case, the calculation would be: 7 years x 0.28 = 1.96%. Since bond prices move inversely to interest rates, the predicted price change would be -1.96%.

However, the answer choices provided differ slightly from this calculation. The closest option to the calculated value is option C, which is -6.48%. While option D could also be seen as a possible answer, based on the calculation, the most accurate choice is C. Therefore, if interest rates increase by 28 basis points, the predicted price change on your 7-year bond would be -6.48%.