Which of the following statements relating to yield volatility is most accurate? If
the term structure of yield volatility is downward sloping, then:
A short-term rates are higher than long-term rates.
B long-term yields are more stable than short-term yields.
C short-term bonds will always experience greater price fluctuation than longterm bonds.
can someone explain me this answer is B
This question is talking about the term structure of Yield Volatility. It is a plot of the Volatility of interest rates and time to maturity.
Option A says Short term rates are higher than long term rates. This is not true as we are not talking about the term structure of yield curve rather we are talking about term structure of yield volatility. So, we have to see volatility of interest rates and not interest rates.
Option C says short term bonds will always have a greater price fluctuation than long term bonds which is not true. You know long term bonds are more volatile than short term bonds and have a higher duration i.e interest rate risk.
Option B says that Long term bonds yields are stable than short term yields which is true. This is correct.
Explanation: You know that Duration of long term bonds is higher than that of short term bonds correct i.e long term bonds are more volatile than short term bonds Correct?
But sometimes what happens is that, due to monetary policy changes of the Govt. ,the %age in short term bonds may be more than the %age in long term bonds.
For eg: If there are some Policy changes of the Govt. in the short term, it may so happen that the ‘r’ i.e interest rate of a short term bond may change more than the ‘r’ of the long term bond. So, the sometimes %age change i.e volatility of short term bonds can be higher than% age change of long term bonds.
See, %age in Bond’s price is composed of 2 things: MD and Interest rate.
MD of a long term bond is obviously higher than a short term bond, however the ‘r’ of a short term bond may change more than a long term bond as a result of which the %age change of short term bonds is more than the %age change in long term bonds.
For eg: Bond A
MD =7 and the interest rate falls by 30 BPS
%age change in Price: 7×0.3=2.1%
Bond B
MD=3 and interest rate falls by 140 BPS
%age change in price= 3×1.4=4.2 %
See, bond B with a shorter MD i.e short term bond has changed more than a long term bond as a result of Higher change in it’s interest rate although the MD of bond A was high. So, long term yields are stable than short term yields.
Please listen to the audio by Sanjay sir regarding the same for better understanding as this is really tricky to understand.