Finance Question?

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... T/F explain

Answer 1

True.

The Fed (in the US) controls short interest rates by changing the Fed funds rate. (Next week, btw, is when the Fed next meets and will announce a decision.) Changes are usually done in 1/4 % increments. When the Fed alters rates, it has an immediate impact on the short end of the curve.

On the long end of the curve, say 30 years out, the Fed isn't directly involved. It is inflationary expectations of investors that drive that end. And inflationary expectations don't dramatically change.  There is really nothing that can have a sudden impact on the far end of the curve that the Fed can have on the short end of the yield curve.

Answer 2

False because of the time factor.

A change in the interest rate of a 90 day T-bill would only influence the price for one quarter of a year. So if rates went up 1% on a 90 day bill you own you are facing losing the opportunity to make that extra 1% for one quarter so that would mean you lose only .25% annual interest. You can buy a new one in 90 days at the new rate when yours matures.

With a 30 year Treasury bill a 1% change would mean a loss, an opportunity cost,  for the whole term or 120 quarters!

So for the same *percentage* change in rates the 30 year rates the price would be 120 times more sensitive.

But this is WHY the long term rates are less volitile because they try to predict the rates over a longer period because the the price is more sensitive to the rates.

There is a balance. Long term rates are less volitile but more sensitive. Short term rates are more volitile but the price is less sensitive because of the short time frame.