Which of the following investments is most affected by changes in the level of interest rates? Suppose interest rates go up or down by 50 basis points (± 0.5%). Rank the investments from most affected (largest change in value) to least affected (smallest change in value).

• $1 million invested in short-term Treasury bills.
• $1 million invested in Treasury strips (zero coupons) maturing in December 2016.
• $1 million invested in a Treasury note maturing in December 2016. The note pays a 5.5% coupon.
• $1 million invested in a Treasury bond maturing in January 2017. The bond pays a 9.25% coupon.

• II > I > IV > III
• I > II > III > IV
• IV > III > II > I
• II > III > IV > I
• II > III > I > IV

References

Lo, Andrew W.; Wang, Jiang. "MIT Sloan Finance Problems and Solutions Collection Finance Theory I" (PDF). alo.mit.edu. Retrieved November 30, 2023.

Solution: D

(II) the entire value of the treasury strip is in the principal repayment in the distant future; it has the highest duration and is most sensitive to a change in the interest rate.

(III) despite having the same maturity as (b), (c) has 5.5% coupon payments that dampen its sensitivity to interest rate changes.

(IV) higher coupon payment → lower duration

(I) T-bills are only for 1 to 6 months; they have the smallest duration.

References

Lo, Andrew W.; Wang, Jiang. "MIT Sloan Finance Problems and Solutions Collection Finance Theory I" (PDF). alo.mit.edu. Retrieved November 30, 2023.