Question

Analyze the risk profiles of short-term bonds and long-term bonds during economic instability and fluctuating interest rates. This is from the book financial markets and instituons global edition 9th edition by mishkin.

Answer 1

The interest rate and the bond price have inverse relationship with each other. As the interest rate rises the bond price decreases, and as the interest rate falls the bond price increase. When we talk about long term bond and short-term bond, longer term bond has higher duration comparative to short term bond because of their maturity period so the interest rate sensitivity of the longer-term bond is higher than the short-term bond. When we talk about the period of economic instability, let’s take the example of current pandemic, what happens is that during the economic instability and pandemic the demand for bond increases and there is withdrawal from the equity markets so when the demand increases their price will also increase. That is also for the fact that during economic disturbances in order to promote investment the central bank would like to keep the interest rate low so again when the rates are low the price of bond will increase but the risk of the long term bond will remain comparatively higher than the short term bond because of the duration factor in these two even during economic instability but the possibility of gain is also high.