I just received a good, tough Series 7 practice question from a customer. She must be using a different company's questions, but this one is worth looking at in some detail:
An investor bought 6% and 7% 15-year municipal bonds at a 5.50 basis. Which bond will have the greatest price appreciation if the market moves to 85.40?
a. 6% bond
b. 7% bond
c. both will appreciate equally
d. neither, since the market moved down
Answer is d. my question is how do we know that 85.40 means the market moved down?
Denise, thanks for sending in this question--not sure who wrote it, but it's about as tricky as it can possibly be. To ask about "the greatest price appreciation," when, in fact, the market price dropped is pretty evil. How do we know that "85.40 means the market moved down?" We have to use reasoning skills. If the coupon/nominal yield on a bond is 6% or 7% when the investor bought it at a yield/basis of just 5.50%, that is a premium bond. Right? If the yield is lower than the nominal/coupon rate, the price is above par. The question then gives you a market price well below par--$854.00. So, the market prices went from above par (premium) to below par (trading at a discount).
Wow. Not sure the actual test will be this evil, but I'm glad somebody's preparing you for even the most evil approach to a tough concept.