Canadian Securities Course (CSC) Level 1 Practice Exam

How does default risk impact interest rates?

1. Default risk has no impact on interest rates

2. If default risk decreases, interest rates rise

3. Increased default risk results in lower interest rates

4. If interest rates rise, companies may have trouble paying back borrowed funds, leading to higher interest rates

The correct answer is: If interest rates rise, companies may have trouble paying back borrowed funds, leading to higher interest rates

Default risk refers to the likelihood that a borrower will be unable to meet the obligations of a loan, such as failing to make timely interest or principal payments. When assessing how default risk impacts interest rates, it's important to understand the relationship between borrowing risk and the cost of borrowing. When investors perceive greater default risk associated with a borrower (be it a corporation or government), they naturally demand a higher interest rate to compensate for the increased likelihood that the investment may not be repaid as expected. Therefore, as default risk rises, lenders incorporate this risk into the rate they charge. Conversely, if the default risk diminishes, potentially due to improved creditworthiness or favorable financial conditions, interest rates would typically decrease, as the lender can proceed with less concern about the possibility of non-repayment. The statement regarding rising interest rates aligns with the understanding that if companies face higher borrowing costs, this can strain their ability to repay loans. When interest rates increase, the financial burden on companies also elevates. If their revenues do not keep pace with these rising costs, it may become more challenging for them to service their debt, which in turn could further elevate concerns about default risk. This cycle highlights how elevated interest rates can flatten demand for new borrowing or investments, thereby exacerb