What are contraction risk and extension risk?

What will be an ideal response?

Contraction risk is the adverse result when mortgage rates decline, while extension risk is the adverse consequence when mortgage rates rise. More details are given below.

An investor who owns pass-through securities does not know what the cash flow will be because that depends on prepayments. To understand this prepayment uncertainty, suppose that an investor buys a 9% coupon Ginnie Mae at a time when mortgage rates are 9%. There will be two adverse consequences if mortgage rates decline to. First, we know from the basic property of fixed-income securities that the price of an option-free bond will rise. But in the case of a
pass-through security, the rise in price will not be as large as that of an option-free bond because a fall in interest rates increases the borrower's incentive to prepay the loan and refinance the debt at a lower rate. Thus, the upside price potential of a pass-through security is truncated because of prepayments. This result should not be surprising, because a mortgage loan effectively grants the borrower the right to call the loan at par value. The second adverse consequence is that the cash flow must be reinvested at a lower rate. These two adverse consequences when mortgage rates decline are referred to as contraction risk.

Now let's look at what happens if mortgage rates rise to 12%. The price of the pass-through, like the price of any bond, will decline. But again it will decline more because the higher rates will tend to slow down the rate of prepayment, in effect increasing the amount invested at the coupon rate, which is lower than the market rate. Prepayments will slow down because homeowners will not refinance or partially prepay their mortgages when mortgage rates are higher than the contract rate of 9%. Of course, this is just the time when investors want prepayments to speed up so that they can reinvest the prepayments at the higher market interest rate. This adverse consequence of rising mortgage rates is called extension risk.