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. Sequential Pay CMO

    A type of collateralized mortgage obligation (CMO) in which there ...
  3. Prepayment Risk

    The risk associated with the early unscheduled return of principal ...
  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 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. Investing Basics

    What is the effect of price inelasticity on demand?

    Find out why price inelasticity of demand shows the relationship between demand and price if the price of an inelastic good is either lowered or raised.
  3. Investing

    Reassessing Your Approach To Bond Investing

    Rethinking your fixed-income portfolio may not resonate in quite the same way as dropping 10 pounds or finally giving up that smoking habit.
  4. Credit & Loans

    Are APRs different in different countries?

    Learn about the term APR and how it is used in the United States and other countries. Explore why different lenders charge different APRs.
  5. Credit & Loans

    What loans do and don't have an APR?

    Learn about what annual percentage rates (APR) are and what they mean. Explore different fixed and variable APRs charge by different lenders.
  6. Mutual Funds & ETFs

    How much of my total assets should I be keeping in my money market account?

    Investing a portion of total assets in a cash position such as a money market account provides investors access to funds in the case of an emergency.
  7. Bonds & Fixed Income

    How does preferred stock differ from company issued bonds?

    Discover the primary differences between preferred stock and corporate bonds, two income-generating investment vehicles issued by certain companies.
  8. Bonds & Fixed Income

    What is the difference between yield to maturity and the yield to call?

    Determining various the various yields that callable bonds can provide investors is an important factor in the bond purchasing process.
  9. Credit & Loans

    What are the pros and cons of owning an equity REIT versus a mortgage REIT?

    Learn about investing in equity, mortgage and hybrid REITs. Explore the different strategies REITs employ to generate income and create dividends.
  10. Bonds & Fixed Income

    How do I calculate yield to maturity of a zero coupon bond?

    Find out how to calculate the yield to maturity for a zero coupon bond, and see why this calculation is more simple than a bond with a coupon.

You May Also Like

Hot Definitions
  1. Treasury Bond - T-Bond

    A marketable, fixed-interest U.S. government debt security with a maturity of more than 10 years. Treasury bonds make interest ...
  2. Weight Of Ice, Snow Or Sleet Insurance

    Financial protection against damage caused to property by winter weather specifically, damage caused if a roof caves in because ...
  3. Weather Insurance

    A type of protection against a financial loss that may be incurred because of rain, snow, storms, wind, fog, undesirable ...
  4. Portfolio Turnover

    A measure of how frequently assets within a fund are bought and sold by the managers. Portfolio turnover is calculated by ...
  5. Commercial Paper

    An unsecured, short-term debt instrument issued by a corporation, typically for the financing of accounts receivable, inventories ...
  6. Federal Funds Rate

    The interest rate at which a depository institution lends funds maintained at the Federal Reserve to another depository institution ...
Trading Center