BOND PRICE VOLATILITY
To use effective bond portfolio strategies, it is necessary to understand the price volatility of
bonds resulting from changes in interest rates. The purpose of this chapter is to explain the price
volatility characteristics of a bond and to present several measures to quantify price volatility.
REVIEW OF THE PRICE-YIELD RELATIONSHIP FOR OPTION-FREE BONDS
An increase (decrease) in the required yield decreases (increases) the present value of its
expected cash flows and therefore decreases (increases) the bond’s price. This relationship is not
linear. The shape of the price-yield relationship for any option-free bond is referred to as a
PRICE VOLATILITY CHARACTERISTICS OF OPTION-FREE BONDS
There are four properties concerning the price volatility of an option-free bond. (i) Although the
prices of all option-free bonds move in the opposite direction from the change in yield required,
the percentage price change is not the same for all bonds. (ii) For very small changes in the yield
required, the percentage price change for a given bond is roughly the same, whether the yield
required increases or decreases. (iii) For large changes in the required yield, the percentage price
change is not the same for an increase in the required yield as it is for a decrease in the required
yield. (iv) For a given large change in basis points, the percentage price increase is greater than
the percentage price decrease.
An explanation for these four properties of bond price volatility lies in the convex shape of the
Characteristics of a Bond that Affect its Price Volatility
There are two characteristics of an option-free bond that determine its price volatility: coupon
and term to maturity.
First, for a given term to maturity and initial yield, the price volatility of a bond is greater, the
lower the coupon rate. This characteristic can be seen by comparing the 9%, 6%, and zero-
coupon bonds with the same maturity. Second, for a given coupon rate and initial yield, the
longer the term to maturity, the greater the price volatility.
MEASURES OF BOND PRICE VOLATILITY
Money managers, arbitrageurs, and traders need to have a way to measure a bond’s price
volatility to implement hedging and trading strategies. Three measures that are commonly