Advanced Diploma of Financial Planning (ADFP) Practice Test

Interest rate risk affects which aspect of securities?

1. Liquidity

2. Value of securities

3. Dividend yields

4. Market share

The correct answer is: Value of securities

Interest rate risk primarily affects the value of securities. When interest rates rise, the present value of future cash flows from fixed-income securities, such as bonds, decreases, leading to a decline in their market value. Investors typically demand higher yields in a rising rate environment, which means that existing securities with lower yields become less attractive, causing their prices to drop. Conversely, when interest rates fall, the value of existing securities tends to increase since their yields become more appealing compared to newly issued securities that may offer lower returns. Thus, understanding this inverse relationship between interest rates and the value of securities is crucial for investors as they manage their portfolios and assess risk. While liquidity, dividend yields, and market share are important aspects of financial products and companies, they are not directly influenced by interest rate fluctuations in the same way that the value of securities is. Liquidity generally relates to how easily a security can be bought or sold without affecting its price, and market share pertains to a company's position in its industry. Dividend yields are affected by changes in dividends or stock prices, but changes in interest rates do not have the same direct impact as they do on the overall valuation of securities.