Contraction Risk

AAA

DEFINITION of 'Contraction Risk'

The risk faced by the holder of a fixed income security when borrowers increase the rate at which they pay back the maturity value of the fixed income security. Contraction risk is a component of prepayment risk that increases as interest rates decline. This is because a decline in rates may create an incentive for the borrower to prepay all or part of the outstanding debt, which results in the life of the debt instrument being reduced. As interest rates decrease, the likelihood of prepayment increases.

INVESTOPEDIA EXPLAINS 'Contraction Risk'

A financial institution that offers a mortgage at an interest rate of 5% expects to earn interest on that investment for the life of the mortgage. However, if the interest rate declines to 3%, the borrower may refinance the loan, or accelerate payments, in order to reduce the number of years that they will have to pay interest to the investor. If the borrower refinances at a lower interest rate, the total payment period is reduced, thus introducing contraction risk.



RELATED TERMS
  1. Fannie Mae - Federal National Mortgage ...

    A government-sponsored enterprise (GSE) that was created in 1938 ...
  2. Prepayment Risk

    The risk associated with the early unscheduled return of principal ...
  3. Extension Risk

    The risk of a security's expected maturity lengthening in duration ...
  4. Mortgage-Backed Security (MBS)

    A type of asset-backed security that is secured by a mortgage ...
  5. Duration

    A measure of the sensitivity of the price (the value of principal) ...
  6. Pass-Through Security

    A pool of fixed-income securities backed by a package of assets. ...
RELATED FAQS
  1. No results found.
Related Articles
  1. Bonds & Fixed Income

    Advanced Bond Concepts

    Learn the complex concepts and calculations for trading bonds including bond pricing, yield, term structure of interest rates and duration.
  2. Economics

    What Would Happen If Interest Rates Rise?

    This time around, while U.S. long-term yields have rebounded from their January lows, rates have generally been lower than where they ended 2014.
  3. Investing

    Strategies To Position Your Bond Portfolio

    Fixed income investors may not be able to see them all right now, but important trends are stirring on the investment horizon.
  4. Credit & Loans

    How To Become a Mortgage-Backed Securities Analyst

    Specializing in structured or derivative credit products like mortgage-backed securities requires education and prior experience in the mortgage field.
  5. Investing

    3 Major Risks For Annaly’s Investors

    Thanks to its double-digit dividend yield, Annaly Capital Management has long been a favorite among income-seeking investors.
  6. Investing

    Ready To Invest In Financial Leverage Funds?

    Whenever you invest in a leveraged financial fund or are thinking about doing so, it's important to know the risks that could weigh on its returns.
  7. Taxes

    Before You Visit Your Tax Preparer: Do This

    The earlier you start preparing your tax records and documents, the more likely you are to have a smooth tax return experience – and all the tax benefits you're due.
  8. Savings

    How To Make Money With Airbnb: Risks & Rewards

    Airbnb lets you turn your home or spare room into extra cash. Here's how to make money and protect yourself from the risks.
  9. Mutual Funds & ETFs

    Consider This High-Yield ETF's Risks and Rewards

    Finding quality high-yield opportunities isn’t easy, but the YieldShares High Income ETF (YYY) has potential.
  10. Trading Strategies

    Eyeing a Loan? Consider Skipping the Banks

    Peer-to-peer lending platforms, such as Lending Tree, Lending Club and Prosper, offer borrowers newfound leverage. Here's a look.

You May Also Like

Hot Definitions
  1. Gordon Growth Model

    A model for determining the intrinsic value of a stock, based on a future series of dividends that grow at a constant rate. ...
  2. Cost Accounting

    A type of accounting process that aims to capture a company's costs of production by assessing the input costs of each step ...
  3. Law Of Supply

    A microeconomic law stating that, all other factors being equal, as the price of a good or service increases, the quantity ...
  4. Investment Grade

    A rating that indicates that a municipal or corporate bond has a relatively low risk of default. Bond rating firms, such ...
  5. Fringe Benefits

    A collection of various benefits provided by an employer, which are exempt from taxation as long as certain conditions are ...
  6. Irrevocable Trust

    A trust that can't be modified or terminated without the permission of the beneficiary. The grantor, having transferred assets ...
Trading Center