Question

Explain the following statement: “Short-term interest rates are more volatile than long-term rates. The prices of long-term bonds are more volatile than those of shorter-term bonds.”

Answer 1

The short term interest rates are more volatile than the long term rates because in an Economy the government first targets the short term rates to control the inflationary or deflationary pressures in the economy and this rate is frequently changed. So, the short term rates are first to be targeted than the long term rates.

The prices of long term bonds are more volatile than short term bonds because as the time to maturity increases, the long term bonds become more sensitive to the changes in interest rates than the short term bonds. Due to the higher duration of the long term bonds, The long term bonds carry a greater risk that inflation would reduce the expected payments in the future. The risk of the bond prices falling due to the effect of higher interest rates is also high with the long term bonds. In the case of short term bonds we can recover the amount invested in a short period of time as against the long term bonds where we are locked in the long term interest rates for a long period of time. The volatility is high in the case of long term bonds.