CFAI 2013 AM – Question 9B

@vincentt @alta12 – to price a bond, it depends on the yield curve. The yield curve is affected by a few factors, e.g.:

– current market interest rates,
– the maturity of the obligation,
– credit risk of the obligation,
– the liquidity of the obligation,
– embedded options,
– tax treatment of the obligation

So assuming everything else (except current interest rates and credit risk of bond issuer) is constant, you can see that even if the credit spread is improving for the issuer, that is not the whole story of what affects the yield curve (that affects bond prices). The long term interest rate could just as well rise and completely offset the effect of improving credit spread to cause a fall in the 30-Y bond.

@vincentt the trade you have done is long duration trade. The question is asking given a credit spread tightening (which is really in the question to throw you off) what is the significant risk with this trade. Major risk with long duration is when long rates rise and bond price decrease. And because they mentioned the credit spread tightening, you have to link the answer back and say the loss from long term rates rise will offset the gain from credit spread tightening.

@vincentt I think the long term rates move independently from the short term rates. @sophie ?