Advanced Diploma of Financial Planning (ADFP) Practice Test

Which risk refers to the variability of a security's returns caused by changes in interest rates?

1. Market risk

2. Credit risk

3. Interest rate risk

4. Liquidity risk

The correct answer is: Interest rate risk

Interest rate risk refers to the variability of a security's returns that is caused by fluctuations in interest rates. This concept is particularly relevant for bonds and interest-sensitive investments, as changes in interest rates can directly impact their prices and yields. When interest rates rise, the prices of existing bonds typically fall, leading to a decrease in their market value. Conversely, if interest rates decrease, the prices of existing bonds tend to rise. Understanding this risk is crucial for investors, as it can significantly affect the overall performance of their fixed-income portfolios and any other interest-sensitive securities they hold. Market risk pertains to the chance of investment losses due to overall market movements, while credit risk involves potential losses due to a borrower's failure to repay a loan or meet contractual obligations. Liquidity risk refers to the difficulty of buying or selling an investment without affecting its price. Each of these risks plays a different role in the investment landscape, but interest rate risk specifically addresses the impact of changes in interest rates on security returns.