Question

The values of outstanding bonds change whenever the going rate of interest changes. In general, short-term interest rates are more volatile than long-term interest rates. Therefore, short-term bond prices are more sensitive to interest rate changes than are long-term bond prices. Is that statement true or false? Explain. (Hint: Make up a "reasonable" example based on a 1-year and a 20-year bond to help answer the question.)

Answer 1

Answer: False

Explanation:

The volatile short-term interest rates do not affect long-term bonds simply because they are long term.

When it comes to general interest however, Long term bond prices are more volatile to interest rate changes than short term bonds. This is because of how bond prices are calculated.

Bonds are calculated by discounting cashflows over the life of the bond. For a longer term bond therefore, there will be more cashflows over longer periods that need discounting. If rates were to change therefore, the present value of the cashflows especially for the ones further away, will be affected more therefore the long term bond price will be affected more as well.

For example;

Take a 6% $1,000 bond, maturing in a year and a 6% $1,000 bond maturing in 20 years. Assume Yield to be 6% as well.

As the coupon rates equal the yield, both prices will be $1,000

Now assuming the Yield changes to 5%.

Using financial calculators, the 1-year bond will now be priced at $1,009.52

The 20 year bond however will now be priced at $1,124.62.

Conclusion: Long-term bond prices are more sensitive to interest rate changes than short-term bonds.