Chartered Financial Analyst (CFA) Practice Exam Level 2

What does modified duration measure in relation to bond price changes?

1. The sensitivity of a bond's price to interest rate changes

2. The total return on the bond

3. The comparison of current price to market value

4. The effect of credit risk on pricing

The correct answer is: The sensitivity of a bond's price to interest rate changes

Modified duration specifically quantifies a bond's price sensitivity to changes in interest rates. It provides a measure of how much the price of a bond is expected to change in response to a 1% change in yield. This is particularly important for bond investors, as it helps them assess the interest rate risk associated with a bond investment. For instance, if a bond has a modified duration of 5, it implies that if interest rates were to rise by 1%, the bond's price would decrease by approximately 5%. Conversely, if rates were to fall by 1%, the bond's price would increase by about 5%. This relationship highlights the inverse correlation between bond prices and interest rates, making modified duration a crucial tool for effective bond portfolio management and risk assessment. Other responses do not directly address the relationship between bond prices and interest rates. Total return on the bond involves multiple factors including coupon payments and price appreciation rather than just price sensitivity to interest rate changes. Comparing current price to market value does not provide insight into the interest rate risk of the bond. Lastly, credit risk's effect on pricing is a different aspect altogether, focusing on the risk of default rather than the impact of interest rate fluctuations on bond prices.