Practice Question
Evaluating Bond Price-Yield Curve:
The convex shape of the bond price-yield curve shows:
I. The curve is always downward sloping.
II. The curve is flatter when the yield is high.
III. For 1% changes in the interest rate, the decreases in the bond price when the interest rate increases are greater than increases in the bond price when the interest rate decreases.
Select one:
A. Only I is correct.
B. Both I and II are correct.
C. Both I and III are correct.
D. All statements are correct.
This is correct. The bond price-yield curve is downward sloping: as yield increases, the present value of future cash flows (i.e., the bond price) decreases.
This is correct. The curve becomes flatter at higher yields, reflecting reduced sensitivity of bond price to interest rate changes at those yield levels.
This is incorrect. Convexity implies the opposite: when interest rates decrease, the price of the bond increases more than it decreases when interest rates rise by the same amount.
Only statements I and II are consistent with the convex shape of the bond price-yield curve.
Final Answer: B) Both I and II are correct.