What is 'Extension Risk'

Extension risk is the risk of a security's expected maturity lengthening in duration due to the deceleration of prepayments. Extension risk is mainly the result of rising interest rates, and is generally associated with mortgage-related securities. The opposite of extension risk is prepayment risk, which generally occurs in a declining interest rate environment, and is associated with people paying off their loans too quickly.

BREAKING DOWN 'Extension Risk'

As interest rates rise, the likelihood of prepayment decreases as people will be less likely to refinance their homes. If the loans in a pool underlying a mortgage-related security are being prepaid at a slower rate, investors are unable to capitalize on higher interest rates because their investments are locked in at a lower rate for a longer period of time. As interest rates decline, however, the likelihood of prepayment increases because refinancing becomes more attractive. When a loan is refinanced, the original loan gets paid off, and investors then have to invest their proceeds at the new, lower market rate.




RELATED TERMS
  1. Prepayment

    The satisfaction of a debt or installment payment before its ...
  2. Prepayment Model

    A model used to estimate the level of prepayments on a loan portfolio ...
  3. Contraction Risk

    The risk faced by the holder of a fixed income security when ...
  4. Public Securities Association Standard ...

    An assumed monthly rate of prepayment that is annualized to the ...
  5. Single Monthly Mortality - SMM

    In mortgage-backed securities (MBSs), this is the percentage ...
  6. Burnout

    A period of slowing mortgage prepayment within a mortgage backed ...
Related Articles
  1. Investing

    The Risks Of Mortgage-Backed Securities

    Find out how weighted average life guards against prepayment risk.
  2. Investing

    Defeasance Reduces Commercial Real Estate Fees

    Try this alternative to short-term variable-rate financing when using leverage to buy property.
  3. Investing

    Introduction To Asset-Backed And Mortgage-Backed Securities

    In this article, we will go through the structure, along with some examples of ABS and valuation.
  4. Investing

    Senior Floating Rate Loans Provide Income and Value

    While equity volatility prompted handwringing among investors, one of the most vexing issues in the current environment is in the fixed income market.
  5. Personal Finance

    How Banks Set Interest Rates on Your Loans

    Many factors go into how banks set interest rates for loans. Use this information to negotiate the best possible rate when you're borrowing.
  6. Personal Finance

    Student Loan Debt: Is Consolidation The Answer?

    Consolidating student loans entails taking out a new loan to pay off existing loans. It sounds simple, but there are a few things to keep in mind.
  7. Investing

    What's the Option-Adjusted Spread?

    The option-adjusted spread, or OAS, measures a fixed-income security rate’s spread and the risk-free rate of return that’s adjusted to account for an embedded option.
  8. Investing

    Commercial Real Estate Loans

    Obtaining a commercial real estate loan is quite different from borrowing for residential real estate. Here's what to expect and how to get what you need.
  9. Insights

    Forces Behind Interest Rates

    Get a deeper understanding of the importance of interest rates and what makes them change.
RELATED FAQS
  1. Do prepayments provide working capital?

    Learn how prepayments for various services such as insurance, rent and supplies are included as part of a company's current ... Read Answer >>
  2. Do FHA loans have prepayment penalties?

    Learn whether FHA loans have prepayment penalties, and find out the rules governing interest charges when prepaying your ... Read Answer >>
  3. Which is better, a fixed or variable rate loan?

    A variable interest rate loan is a loan in which the interest rate charged on the outstanding balance varies as market interest ... Read Answer >>
Trading Center