Question

2. Calculate and plot the price of a security with the following characteristics at current market interest rates of 4%, 8% and 12%: Coupon equals 8%, maturity equals five years, face value equals $1,000. (Place price on the vertical (Y) axis and the current yield on the horizontal (X) axis.) Without doing the calculations, would the curve for a ten-year security be steeper or flatter than the one you have plotted? Why? What about a one-year security? Why?

I have made the graphs but I cannot properly articulate the "why" questions.

Answer 1

1: The curve for a 10 year security would be steeper than the curve for a 5 year one. This is because a higher period will cause more fluctuations due to higher uncertainty in the changes in interest rates. Hence longer term bonds are more volatile and so this will cause the curve to be steeper.

2: The converse will happen for a security with a 1 year maturity. Due to a lower term, there is lesser volatility and so the curve for this security will be flatter. Due to shorter term, there is less risk of changes in interest rates and thereby prices making it lesser volatile.