johnnyBuz

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.