Impact of Interest Rate Volatility on Bond Sensitivity

Very Hard Term Structure Dynamics Interest Rate Volatility

In a recent analysis of interest rate dynamics, Patricia, a quantitative analyst, examined the term structure of interest rates for government bonds. She focused closely on the impact of interest rate volatility on the prices of these bonds, particularly in reaction to changes in the economic environment.

She identified that as interest rates rise, bond prices typically fall, and this relationship is generally straightforward. However, she noted anomalies based on the volatility of interest rates. An important observation made by Patricia was that higher interest rate volatility can have differing impacts on the term structure of interest rates, particularly affecting bonds with different maturities.

Given her findings, Patricia categorizes the implications of interest rate volatility into three distinct scenarios. Which of the following statements correctly identifies the relationship between interest rate volatility and bond price sensitivity regarding the term structure?

An increase in interest rate volatility decreases the sensitivity of long-term bonds to interest rate changes compared to short-term bonds.

An increase in interest rate volatility increases the sensitivity of both short-term and long-term bonds equally to interest rate changes.

An increase in interest rate volatility increases the sensitivity of long-term bonds to interest rate changes more than that of short-term bonds.

Hint

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