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. Duration

    A measure of the sensitivity of the price (the value of principal) ...
  2. Sequential Pay CMO

    A type of collateralized mortgage obligation (CMO) in which there ...
  3. Planned Amortization Class (PAC) ...

    A class of tranche in a planned amortization class (PAC) bond ...
  4. Companion Bond

    A class of tranche found in a planned amortization class (PAC) ...
  5. Vintage

    A slang term used by mortgage-backed securities (MBS) traders ...
  6. Extension Risk

    The risk of a security's expected maturity lengthening in duration ...
Related Articles
  1. Advanced Bond Concepts
    Bonds & Fixed Income

    Advanced Bond Concepts

  2. What You Need To Know About Preferred ...
    Trading Strategies

    What You Need To Know About Preferred ...

  3. Finding And Investing In FHA Condos
    Investing Basics

    Finding And Investing In FHA Condos

  4. Saving Money Or Paying Off Debt?
    Credit & Loans

    Saving Money Or Paying Off Debt?

comments powered by Disqus
Hot Definitions
  1. Days Sales Of Inventory - DSI

    A financial measure of a company's performance that gives investors an idea of how long it takes a company to turn its inventory ...
  2. Accounts Payable - AP

    An accounting entry that represents an entity's obligation to pay off a short-term debt to its creditors. The accounts payable ...
  3. Ratio Analysis

    Quantitative analysis of information contained in a company’s financial statements. Ratio analysis is based on line items ...
  4. Days Payable Outstanding - DPO

    A company's average payable period. Calculated as: ending accounts payable / (cost of sales/number of days).
  5. Net Sales

    The amount of sales generated by a company after the deduction of returns, allowances for damaged or missing goods and any ...
  6. Over The Counter

    A security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, etc. The phrase "over-the-counter" ...
Trading Center