Understanding Interest Rate and Price Risk in Bonds: 1-Year vs 10-Year Bonds

Interest Rate Risk refers to the potential for investment losses that occur due to changes in interest rates. When interest rates rise, the prices of existing bonds typically fall because new bonds are issued at higher rates, making the older bonds with lower rates less attractive. Conversely, if interest rates fall, the prices of existing bonds generally rise.

Comparing Interest Rate Risks of Bonds: 1-Year Bond vs 10-Year Bond

1-Year Bond

This bond matures in one year and pays interest annually. Because it has a short duration, its price is less sensitive to interest rate changes. If interest rates rise, the bond will mature soon, allowing the investor to reinvest at the new higher rates without a significant loss in value.

10-Year Bond

This bond has a much longer maturity. It is more exposed to interest rate fluctuations because it locks in the interest rate for a longer period. If interest rates rise, the price of this bond will decrease more significantly than that of the 1-year bond.

Conclusion: Which Bond Has More Interest Rate Risk?

The 10-year bond has more interest rate risk than the 1-year bond. The longer the duration of the bond, the greater the impact of interest rate changes on its price, making longer-term bonds more sensitive to interest rate fluctuations.

Price Risk and Related Measures

Price risk is a measurement of how much the bond price will go up or down for a small change in yield. Two related measurements, Macaulay Duration and Modified Duration, are often used to determine this risk. The bond with the longer duration, such as the 10-year bond, is more price sensitive.

Derivatives and Price-Risk Relationship

Both duration calculations are closely related to the derivative of the Price-Yield function. Derivatives tell you the rate of change relative to the input. This means that as interest rates change, the bond's price will also change, and the amount of this change is determined by the bond's duration.

Real-Life Example

Interest rate risk is the risk that interest rates move against you. For example, you have an investment in bonds and intend to sell after a few months. If interest rates rise, your bonds are now worth less than you paid for them.

The simple explanation is this: Bond Price Change (Current Market Rate - Bond Rate) * Years Duration Remaining. So, the longer the bond will be outstanding, the greater your exposure to interest rate risk.