Impact of Interest Rate Volatility on Bond Prices

Hard Term Structure Dynamics Interest Rate Volatility

In the study of term structure dynamics, interest rate volatility plays a crucial role in the valuation of fixed income securities. Assume the interest rate model is based on the Vasicek model, which suggests that interest rates revert to a long-term mean and exhibit random, normally distributed shocks. Given this framework, how do changes in interest rate volatility impact the prices of long-term versus short-term bonds?

Increased volatility leads to greater price sensitivity for short-term bonds than long-term bonds.

Increased volatility affects long-term bonds more, making them riskier and more sensitive to changes in interest rates.

Increased volatility has no effect on the price sensitivity of bonds regardless of their term structure.

Hint

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