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LOS 34.m: Explain the maturity structure of yield READING 34: THE TERM STRUCTURE AND
volatilities and their effect on price volatility. INTEREST RATE DYNAMICS
MODULE 34.5: TERM STRUCTURE THEORY
The term structure of interest rate volatility is the graph of yield volatility versus maturity. It is important because interest
rate volatility is a key concern for bond managers because interest rate volatility drives price volatility in a fixed income
portfolio, especially when securities have embedded options, which are especially sensitive to volatility.
Figure 34.4 shows a typical term structure of interest rate volatility. Short-term interest rates are generally more volatile
than are long-term rates.
Volatility at the long-maturity end is thought to be associated with uncertainty regarding the real economy and inflation, while
volatility at the short-maturity end reflects risks regarding monetary policy.
Interest rate volatility at time t for a security with maturity of T is denoted as σ(t,T). This variable measures the annualized
standard deviation of the change in bond yield.
