A newly issued bond has a maturity of 4 years and pays a 7% annual coupon. The current discount rate is 6.75%, and the face value is $1000.
(a) What is the price of this bond?
(b) What is the duration of the bond?
(c) Find the price of this bond if rates decrease by 1 bp (basis point) using the duration rule for price sensitivity. Then, re-price the bond using the normal bond pricing formula or your financial calculator. How much is the pricing error from the duration rule?
(d) Perform the same steps for a 100 bp decrease in interest rate. What is the pricing error now?
(e) What is the name of the effect that is causing what you are observing?