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Answer: Negative convexity
## Explanation This bond is **callable** and trades **close to par**, which are key characteristics. When yields decrease sharply: - **Callable bonds exhibit negative convexity** because as interest rates fall, the likelihood of the bond being called increases - The issuer is likely to call the bond when rates fall, limiting the bond's price appreciation - This creates a price ceiling effect where the bond price cannot rise much above the call price - **Negative convexity** means the bond's duration decreases as yields fall (opposite of normal bonds) **Modified duration** and **effective duration** would typically decrease rather than increase in this scenario due to the call feature. **Positive convexity** is characteristic of non-callable bonds, not callable bonds trading near par.
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Bonds issued by the XYZ Corp. are currently callable at par value and trade close to par. The bonds mature in 8 years and have a coupon of 8%. The yield on the XYZ bonds is 175 basis points over 8-year US Treasury securities, and the Treasury spot yield curve has a normal, rising shape. If the yield on bonds comparable to the XYZ bond decreases sharply, the XYZ bonds will most likely exhibit:
A
Negative convexity
B
Increasing modified duration
C
Increasing effective duration
D
Positive convexity
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