The Francesca Finance Corporation has issued a bond with the following characteristics:
Yield to maturity—9%
Callable—after 3 years @ 109
Duration to maturity—8.2 years
Duration to first call—2.1 years
a. Discuss the concept of call-adjusted duration, and indicate the approximate value (range) for it at the present time.
b. Assuming interest rates increase substantially (i.e., to 13 percent), discuss what will happen to the call-adjusted duration and the reason for the change.
c. Assuming interest rates decline substantially (i.e., they decline to 4 percent), discuss what will happen to the bond’s call-adjusted duration and the reason for the change.
d. Discuss the concept of negative convexity as it relates to this bond.