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CP1 Notes - Chp11 - Pg13

D

Darragh Kelly

Ton up Member
Hi,

On page 13 of chapter 11, a question covers the relative liquidity of short term and long term government bonds.
So long term bond prices are obviouslty more volatile then short term, because in the long term much more can happen in the economy which could influence the supply and demand for long term bonds? So we'd expect alot of price changes hence volatility?
So then how are short-dated bonds more liquid if they are less volatile? I get they'd be more liquid because of the short term commitments ie you're not locked in for a long duration so easier to sell the bond vs long term.

Thanks,

Darragh
 
Hi Darragh

The idea this question covers is that liquidity reduces with the term of an investment and there is generally a negative relationship between liquidity and volatility when comparing like with like (government bonds in this case). The more easily something can be converted into cash, the more liquid it is and the more certainty there is about its value; the volatility of its value will then lower as economic movements will impact less.

Short-dated government bonds will be redeemed soon and so a certain amount of money will be received in the short term. Even if it's necessary to liquidate this asset earlier, a buyer will recognise this and pay a price that's relatively close to the redemption amount, limiting volatility for the seller.

By contrast, long-dated bonds will not be redeemed for some time so, as you say, there's a lot more uncertainty in the value of these bonds. Investors will need to place more reliance on estimates of value based on economic variables. For example, mathematically, the present value of these bonds (ie an estimate) will vary more with discount rate changes as redemption processes (and some coupons) will not be received for a long time. (There will be little or no discounting of redemption proceeds for a short-term bond.)

Hopefully this helps.
 
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