Relative volatilityof short and long term interest rates?

Question

short term rates are more volatile than long term rates. why is that? why and how does that volatility male a short term financing strategy risky?

Answer 1

Because long term rates apply to the long term?

Think of yourself first as a potential lender. Under what circumstances would you be willing to make a short term loan? Under what circumstances a long term loan?

Now think of yourself as a borrower. Under what circumstances would you be interested in a short term loan and why? Ditto for long term loans?

I think you'll find that both ways, long term loans are for people, institutions, and projects that are in it for the long(er) haul and so less concerned about the day-to-day changes as compared with the long term prospects. Long term prospects don't change as rapidly and so the corresponding interest rates show less volatility.

As for financing, the general rule is to suit the loan to the underlying purpose.

If you've just sold $1M worth of goods, you may not actually get paid for a month or two. Still, you need the money now to continue production. So you get a loan using your accounts receivable (the money your customers owe you) as collateral. Would it make more sense to get a 10 year loan or a 3 month loan in this case?

If, on the other hand, you are planning a new factory which will take several years to get built and start producing, an important part of the total cost is going to be the financing cost. Wouldn't you feel better knowing what is going to be in advance by locking in a known long term interest rate? (Look what has happened in the sub-prime market when people didn't do that.)

Here are some articles, lightweight, but germane to the issue:
http://www.allbusiness.com/business-finance/business-loans-short-term-debt/3529-1.html
http://www.bankrate.com/brm/news/biz/green/19990823b.asp

Answer 2

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RE :Relative volatilityof short and long term interest rates?
short term rates are more volatile than long term rates. why is that? why and how does that volatility male a short term financing strategy risky?
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Answer 3

That's a good question, I was wondering the same thing myself