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. Planned Amortization Class (PAC) ...

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

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

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

    The risk of a security's expected maturity lengthening in duration ...
  5. Fannie Mae - Federal National Mortgage ...

    A government-sponsored enterprise (GSE) that was created in 1938 ...
  6. Mortgage-Backed Security (MBS)

    A type of asset-backed security that is secured by a mortgage ...
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. Home & Auto

    Where are home values falling the fastest in the US, and why?

    Learn about the metropolitan areas in the United States experiencing the largest drops in median single family homes values in 2014 and the reasons behind it.
  3. FHA mortgages offer flexibility and low down payments, though they're often pricier than traditional loans backed by private mortgage insurance.
    Credit & Loans

    Before You Choose An FHA Mortgage: 7 Key Points

    FHA mortgages offer flexibility and low down payments, though they're often pricier than traditional loans backed by private mortgage insurance.
  4. Options & Futures

    Writing Covered Calls On ETFs

    The strategy of writing covered calls on ETFs can limit your losses and hedge risk, but they cap your upside potential.
  5. Home & Auto

    How did the ABX index behave during the 2008 subprime mortgage crisis?

    Read about the disastrous performance of the various ABX indexes in the subprime mortgage crisis of 2008 during the middle of the Great Recession.
  6. FHA loans are often a good alternative for those who have trouble obtaining a conventional mortgage, although you do have to pay an insurance premium.
    Home & Auto

    Mortgage For A Manufactured Home? Try The FHA

    FHA loans are often a good alternative for those who have trouble obtaining a conventional mortgage, although you do have to pay an insurance premium.
  7. Mutual Funds & ETFs

    How do traders use the ABX index?

    Learn about some of the ways traders, banks and even hedge funds have traditionally used the ABX indices to make bets on mortgage-backed securities.
  8. Bonds & Fixed Income

    What determines the price of a bond in the open market?

    Learn more about some of the factors that influence the valuation of bonds on the open market, and why bond prices and yields move in opposite directions.
  9. You're probably moving a lot and still paying off your student loans. Is it crazy to get a mortgage in your 20s? Here's how to decide.
    Credit & Loans

    Does A Mortgage Make Sense If You're In Your 20s?

    You're probably moving a lot and still paying off your student loans. Is it crazy to get a mortgage in your 20s? Here's how to decide.
  10. The credit crunch and recession caused financial fear, so it's no great shock that our borrowing habits have changed from less than a decade ago.
    Credit & Loans

    How Our Borrowing Habits Have Changed In A Decade

    The credit crunch and recession caused financial fear, so it's no great shock that our borrowing habits have changed from less than a decade ago.

You May Also Like

Hot Definitions
  1. SWOT Analysis

    A tool that identifies the strengths, weaknesses, opportunities and threats of an organization. Specifically, SWOT is a basic, ...
  2. Simple Interest

    A quick method of calculating the interest charge on a loan. Simple interest is determined by multiplying the interest rate ...
  3. Special Administrative Region - SAR

    Unique geographical areas with a high degree of autonomy set up by the People's Republic of China. The Special Administrative ...
  4. Annual Percentage Rate - APR

    The annual rate that is charged for borrowing (or made by investing), expressed as a single percentage number that represents ...
  5. Free Carrier - FCA

    A trade term requiring the seller to deliver goods to a named airport, terminal, or other place where the carrier operates. ...
  6. Law Of Supply And Demand

    A theory explaining the interaction between the supply of a resource and the demand for that resource. The law of supply ...
Trading Center