Answer: Both bond prices will move down, but bond B will lose more than bond A.

The correct answer to the question is D. Both bond prices will move down, but bond B will lose more than bond A. This is due to the relationship between bond prices and yield changes. The formula provided in the explanation, △P = -PAy*D, indicates that the price change (△P) is inversely proportional to the yield change (Ay) and the duration (D) of the bond. In the scenario described, both bonds A and B have a modified duration of 3 years and a face value of USD 1,000. However, bond A is a zero-coupon bond with a current price of USD 900, while bond B pays annual coupons and is priced at par (USD 1,000). When there is a parallel upward shift in the yield curve of 1%, it implies that the required yield for investors to hold these bonds has increased. Since bond prices and yields move in opposite directions (when yields go up, prices go down, and vice versa), both bonds will experience a decrease in price. However, bond B, which pays annual coupons, will be more sensitive to the yield change due to its coupon payments. The coupon payments are reinvested at the new higher yield, which affects the bond's total return and thus its price more significantly than for bond A, which does not have coupon payments. The modified duration, which is a measure of a bond's sensitivity to interest rate changes, is the same for both bonds (3 years). However, because bond B is priced at par and pays coupons, it has a higher current price compared to bond A, which is priced below its face value. The impact of the yield curve movement is stronger in absolute terms for the bond that is currently priced higher, which in this case is bond B. Therefore, bond B will experience a greater price decrease than bond A when yields rise.

Author: LeetQuiz Editorial Team