Credit risk and interest rate risk cannot affect insolvency risk.

Question

BlackTom AI · Accepted Answer

Question restatement: The prompt asks whether credit risk and interest rate risk cannot affect insolvency risk, and provides two options: TRUE or FALSE.
Option TRUE: Saying that credit risk and interest rate risk cannot affect insolvency risk is incorrect. In reality, both credit risk (the risk that counterparties fail to meet obligations) and interest rate risk (the risk that changes in rates affect a firm’s borrowing costs and asset values) can influence a company’s liquidity and equity, thereby impacting insolvency risk. If a borrower or counterparty defaults or refinancing becomes expensive due to rising rates, cash flows can deteriorate and insolvency risk may rise.
Option FALSE: This statement is correct because it correctly asserts that there is a link between credit risk, interest rate risk, and insolvency risk. When credit risk materializes, default probabilities increase and potential losses affect capitalization. When interest rates move, debt service costs can increase and asset valuations can change, both of which can erode a firm’s solvency and push it toward insolvency under stressed conditions.
Additional nuance: Insolvency risk is often driven by a combination of factors, including liquidity constraints, funding gaps, and leverage, all of which can be aggravated by credit and interest rate dynamics. Thus, it is consistent with financial risk management to acknowledge that these risks interact and can contribute to insolvency risk rather than being isolated and incapable of affecting it.
Summary of reasoning: The claim in option TRUE incorrectly asserts no connection; the claim in option FALSE correctly acknowledges that credit risk and interest rate risk do influence insolvency risk due to their effects on cash flows, debt service, and balance sheet health.

Credit risk and interest rate risk cannot affect insolvency risk.

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