Question

3. Prices of long-term bonds are more volatile than the prices of short-term bonds.

However, yields to maturity of short-term bonds make their prices and their rates of return more volatile.

How do you reconcile these two empirical observations?

Answer 1

While it is true that short-term rates are more volatile than long-term rates, the longer duration of the longer-term bonds makes their rates of return more volatile. The higher duration magnifies the sensitivity to interest-rate savings. Thus, it can be true that rates of short-term bonds are more volatile, but the prices of long-term bonds are more volatile. A long-term bond has more time to maturity than a short-term bond, so any changes in rate will be spread over a longer time leading to a less volatile YTM. Small changes in yield for a short term bond will be spread over a shorter time, leading to a more volatile YTM.