Credit Risk Management Practice Exam

What impact does the marginal change in the Spread '01 experience as the spread increases?

1. It remains constant

2. It decreases

3. It increases significantly

4. It becomes unpredictable

The correct answer is: It decreases

The marginal change in the Spread '01, which measures the change in the dollar value of a bond's price for a one basis point change in yield, will typically decrease as the spread increases. This phenomenon can be attributed to the convexity of the bond pricing relationship. As spreads widen, the price sensitivity decreases; this means that while the dollar value change per basis point may initially have been larger at lower spread levels, the impact starts to taper off at higher spreads. This decreasing sensitivity indicates that investors perceive greater risk as credit spreads widen, and thus the response of the bond's price to changes in the spread becomes less pronounced. Additionally, as spreads increase, the market dynamics and investor behavior change, often leading to adjustments in how prices react to yield fluctuations. This makes the relationship between price changes and spread movements less linear and more diminishing, affirming that the marginal impact decreases rather than remains the same or increases unpredictably.