the effects of a decrease in interest rate (yield volatility) on the market yield of a debt security with a prepayment option is most likely… A. increase B. decrease the correct answer is B but im not sure why… what does the question mean by a decrease in interest rate volatility?
I may be wrong, but here’s how I understand it: Firstly, volatility risk is the exposure to fluctuations in the market. In this case we are talking about changes in the interest rate. Stable economy==> lower volatility risk. Shaky economy==>higher volatility risk. The security in question has prepayment option, which implies that it carries a call option. A general rule is that the higher volatility in the market, the higher the value of your option (because there’s greater probability it will be in the money). When you value a debt security with an embedded call option, you subtract the value of the option from the price of the bond with no embedded option. The question asks about a low volatility and that implies==>lower option value==>higher price of the debt option. And we know that price of a bond and yield are inversely related, so the yield will decrease. I hope this helps.
Thanks for your answer Ruby! Does a decrease in interest rate volatility have anything to do with moving along the price/yield curve? Or are those unrelated concepts?
The way I answered the question: When interest rate decreases, the borrower (issuer of the debt security) can pay down the principal amounts faster thanks to the repayment option (because their incremental borrowing rate has decreased, and therefore they can borrow at cheaper rate, and retire debts that were issued when interest rates were high). What this means to the lenders is that they are getting more of their principals back sooner than they expected, which means that the original debt will make less payments as a result of the reduced principal amount. Therefore, the yield of the original debt security will fall. Additional consideration: the lender will also have to reinvest the returned principal at the current, lower interest rate, which also means lower returns for them.
Ruby’s spot on… again 
I am just going to make a minor tweak to her post below (in caps): Ruby527 Wrote: ------------------------------------------------------- > I may be wrong, but here’s how I understand it: > > Firstly, volatility risk is the exposure to > fluctuations in the market. In this case we are > talking about changes in the interest rate. Stable > economy==> lower volatility risk. Shaky > economy==>higher volatility risk. > > The security in question has prepayment option, > which implies that it carries a call option. A > general rule is that the higher volatility in the > market, the higher the value of your option > (because there’s greater probability it will be in > the money). When you value a debt security with an > embedded call option, you subtract the value of > the option from the price of the bond with no > embedded option. The question asks about a low > volatility and that implies==>lower option > value==>higher price of the BOND WITH THE EMBEDDED CALL/ PREPAYMENT OPTION. And we > know that price of a bond and yield are inversely > related, so the yield will decrease. > > I hope this helps.