Short Dated vs. Long Dated Default Free Government Bond - Hedge Against Bad Times

Reading 46 EOC, q.18

Why is the answer B? Why do we say that short dated default free government bond are a good hedge against bad times? I thought that a good hedge against bad times were the long dated default free government bond since we can earn a fixed income over a long time period vs a short one

What does the curriculum say?

the curriculum says the following:
The relative certainty about the real payoff from short-dated,default-free government bonds, and therefore the relative certainty about the amount of consumption that the investor will be able to undertake with the pay-off, indicates that an investment in such bonds would be a good hedge against bad consumption outcomes.

Are we trying to say that short dated bonds will give us certain income versus long dated bonds which is why we should invest short dated bonds?

If for example, you are looking at hedging against poor consumption outcomes for a 1-year period, a 1-year default-free bond will give a more definite payoff (i.e. you will get the face value when the 1-year bond matures).

Compare that to buying a 10-year default-free bond, where the price in 1 year’s time is uncertain (i.e. it could be high or low depending on multiple factors :arrow_right: payoff is uncertain in 1-year’s time).

In this case, the 1-year default-free bond provides a better hedge against poor economic outcomes than compared to the 10-year default-free bond.

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thank you :slight_smile:

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