Impact of Interest Rate Volatility on Fixed-Income Securities

Very Hard Term Structure Dynamics Interest Rate Volatility

Consider a hypothetical fixed-income security that is sensitive to changes in interest rate volatility and has a duration of 5 years. Recent research suggests that this security's price is influenced not just by the level of interest rates but also by the volatility of these rates. Assume that a significant increase in interest rate volatility occurs due to economic uncertainty, leading to an increase in the implied volatility of interest rates.

Which of the following statements regarding the impact of increased interest rate volatility on the price of this fixed-income security is correct?

Increased interest rate volatility will generally increase the security's price due to the potential for greater price swings.

Increased interest rate volatility will result in a lower yield for the security as investors demand greater compensation for bearing risk.

Increased interest rate volatility generally leads to a decrease in the price of the security as the risk of adverse price movements becomes greater.

Hint

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