For large interest rate increases, duration _____________ the fall in security prices, and for large interest rate decreases, duration ______________ the rise in security prices.

Question

Quizplus · Accepted Answer

Duration is a measure of the sensitivity of a bond's price to changes in interest rates. For large interest rate increases, the duration overpredicts the fall in security prices because it assumes that the bond's cash flows are unchanged, but in reality, the issuer may be able to call the bond or the investor may reinvest the cash flows at a higher rate, reducing the impact of the interest rate increase. On the other hand, for large interest rate decreases, the duration underpredicts the rise in security prices because it assumes that the bond's cash flows are unchanged, but in reality, the issuer may not call the bond or the investor may not be able to reinvest the cash flows at a lower rate, increasing the impact of the interest rate decrease.

For Large Interest Rate Increases, Duration _____________ the Fall in Security