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.

BREAKING DOWN '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 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. Bonds & Fixed Income

    Calculating Yield to Worst

    Yield to worst is the lowest possible yield on a bond that may be called in the future.
  3. Mutual Funds & ETFs

    ETF Analysis: iShares Floating Rate Bond

    Explore detailed analysis and information of the iShares Floating Rate Bond ETF, and learn how to use this ETF as a defense against rising interest rates.
  4. Mutual Funds & ETFs

    ETF Analysis: Vanguard Intermediate-Term Corp Bd

    Learn about the Vanguard Intermediate-Term Corporate Bond ETF, and explore detailed analysis of the fund's characteristics, risks and historical statistics.
  5. Credit & Loans

    5 Signs a Reverse Mortgage Is a Bad Idea

    Here are the key situations when you should probably pass on this type of home loan.
  6. Credit & Loans

    5 Signs a Reverse Mortgage Is a Good Idea

    If these five criteria describe your situation, a reverse mortgage might be a good idea for you.
  7. Investing News

    Fund Firm Jolts: Pimco's Isn't The First Or Worst

    When you business is built on prudence and trust, a lot can go wrong to cost you tons of clients and assets. Here are a few examples.
  8. Mutual Funds & ETFs

    ETF Analysis: iShares JPMorgan USD Emerg Markets Bond

    Learn about the iShares JPMorgan USD Emerging Markets Bond fund, which invests in bonds of sovereign and quasi-sovereign entities from emerging markets.
  9. Credit & Loans

    Guidelines for FHA Reverse Mortgages

    FHA guidelines protect borrowers from major mistakes, prevent lenders from taking advantage of borrowers and encourage lenders to offer reverse mortgages.
  10. Investing Basics

    What's a Treasury Note?

    A treasury note is a U.S. government debt security that offers a fixed interest rate and a maturity date that ranges between one and 10 years.
RELATED FAQS
  1. What are the maximum Social Security disability benefits?

    The maximum Social Security disability benefit amount for a single eligible person in 2015 is $1,165 per month, but you can ... Read Full Answer >>
  2. What is the relationship between the current yield and risk?

    The general relationship between current yield and risk is that they increase in correlation to one another. A higher current ... Read Full Answer >>
  3. What is a 'busted' convertible bond?

    In finance, a convertible bond represents a hybrid security that offers debt and equity features and risks. While a convertible ... Read Full Answer >>
  4. Who or what is backing municipal bonds?

    Municipal bonds are backed by dedicated taxes or revenue sources related to specific projects, or by the full faith and credit ... Read Full Answer >>
  5. What are the differences between debt and equity markets?

    The basic differences between the debt and equity markets include the type of financial interest they represent, the way ... Read Full Answer >>
  6. What does it signify if the term structure of an interest rate's curve is positive?

    When the term structure of interest rates is positive, it is a signal to economists the short-term yields on similar bonds ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Depreciation

    1. A method of allocating the cost of a tangible asset over its useful life. Businesses depreciate long-term assets for both ...
  2. Recession

    A significant decline in activity across the economy, lasting longer than a few months. It is visible in industrial production, ...
  3. Bubble Theory

    A school of thought that believes that the prices of assets can temporarily rise far above their true values and that these ...
  4. Stock Market Crash

    A rapid and often unanticipated drop in stock prices. A stock market crash can be the result of major catastrophic events, ...
  5. Financial Crisis

    A situation in which the value of financial institutions or assets drops rapidly. A financial crisis is often associated ...
  6. Election Period

    The period of time during which an investor who owns an extendable or retractable bond must indicate to the issuer whether ...
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!