Credit Risk Management Practice Exam

How does high volatility of interest rates affect the sensitivity of debt values to interest rate changes?

1. Debt values become more sensitive

2. Debt values have no sensitivity

3. Debt values are less sensitive

4. Debt values fluctuate unpredictably

The correct answer is: Debt values are less sensitive

High volatility of interest rates leads to increased uncertainty in the market, which in turn affects how sensitive debt values are to fluctuations in interest rates. When interest rates are volatile, debt instruments, especially those with longer maturities, generally exhibit higher sensitivity. This is because the present value of future cash flows from these instruments tends to change more dramatically when interest rates fluctuate. For debt values, particularly those characterized by a fixed interest rate, their sensitivity to changes in the interest rate is measured by their duration. When interest rates rise, the present value of future cash flows decreases, leading to a drop in debt value, and vice versa. In periods of high volatility, the degree of this fluctuation in present value is heightened. Bonds, for instance, may experience significant price swings depending on interest rate movements. As such, stating that debt values are less sensitive does not align with the reality that volatility magnifies sensitivity. In fact, during periods of high interest rate volatility, monitoring debt instruments becomes crucial for managing credit risk effectively. Therefore, acknowledging that debt values tend to become more sensitive during high volatility is essential for understanding the implications on credit risk management.