Chartered Financial Analyst (CFA) Practice Exam Level 2

What indicates the effect of interest rate changes on bond prices?

1. Market liquidity dynamics

2. The relationship between duration and spread change

3. The intrinsic rate of return

4. The volatility of the stock market

The correct answer is: The relationship between duration and spread change

The relationship between duration and spread change is a crucial concept in understanding how interest rate changes affect bond prices. Duration measures the sensitivity of a bond's price to changes in interest rates; specifically, it quantifies the percentage change in price for a 1% change in yield. A higher duration implies greater sensitivity, meaning that as interest rates rise, the price of the bond is expected to decrease significantly, and conversely, if interest rates fall, the bond price tends to increase. Moreover, spread changes, which typically refer to the difference in yield between various bonds (often comparing riskier bonds to government bonds), can also influence how bond prices react to changes in interest rates. When interest rates change, the yields on all bonds—including those with longer durations—are affected. Understanding this dynamic helps investors assess risk and make informed decisions regarding bond investments in varying interest rate environments. The other options do not directly encapsulate the relationship between interest rate changes and bond prices in the same detailed manner. Market liquidity dynamics might affect bond pricing, but they do so in a more tangential way. The intrinsic rate of return pertains more to the return on investments over a full period rather than responding to interest rate shifts. The volatility of the stock market is related to equity