Question #22

of 98 If a bond's key rate durations for maturity points shorter than the bond's maturity are negative, it is most likely that the bond being analyzed is a: A) zero coupon bond. B) putable bond. C) callable bond. Explanation If a bond is a zero-coupon bond (or if it has a "very low" coupon), key rate durations for maturity points that are shorter than the maturity of the bond being analyzed are generally negative. For example, the five-year key rate duration for a 10-year zero-coupon bond can be expected to be less than zero. (Module 27.6, LOS 27.k) Eric Rome works in the back office at Finance Solutions, a limited liability firm that specializes in designing basic and sophisticated financial securities. Most of their clients are commercial and investment banks, and the detection, and control of interest rate risk is Financial Solution's competitive advantage. One of their clients is looking to design a fairly straightforward security: a callable bond. The bond pays interest annually over a two-year life, has a 7% coupon payment, and has a par value of $100. The bond is callable in one year at par ($100). Rome uses a binomial tree approach to value the callable bond. He's already determined, using a similar approach, that the value of the option-free counterpart is $102.196. This price came from discounting cash flows at on-the-run rates for the issuer. Those discount rates are given below: Rome is also interested in the 2027 6% convertible bond of Stellar Inc. The bond can be converted into 25 shares of common stock and is trading at $1024. Stellar's current stock price is $32. Comparable nonconvertible bonds currently yield 6%.