What Is Extension Risk?
Extension risk is the risk that borrowers will defer prepayments due to market conditions. It is a risk that is generally analyzed in secondary market structured credit product investments.
For instance, if interest rates rise it might discourage homeowners from re-financing their mortgages, reducing the flow of prepayments. This could extend the duration of the loans in a mortgage backed security (MBS) beyond what the valuation and risk models initially predicted.
Understanding Extension Risk
Extension risk is a secondary market product risk that borrowers will remain in their loan longer deferring the average payment cycle for secondary market product investors. In the primary market, lenders are mainly focused on contraction risk (also known as prepayment risk) which is the risk that a borrower will pay early and thus reduce the interest paid to a lender over the life of a loan.
- Extension risk is the risk that borrowers will defer prepayments due to market conditions.
- Extension risk is mostly a concern in the secondary credit market.
- In the primary credit market, prepayment risk is the larger concern for issuers.
Primary Market Contraction Risk
Primary market lenders issue loans to borrowers with the hopes that the borrower will not prepay early which decreases the interest a lender earns on a loan. Some lenders even institute prepayment fees for early payoff to offset losses. With a fixed rate loan borrowers have greater incentive to payoff their loan specifically from a refinancing perspective when rates are falling. This causes contraction risk for primary lenders since more borrowers are likely to prepay.
With variable rate loans primary market borrowers will see higher prepayment when rates are rising which also increases contraction risk. When rates rise borrowers have greater incentive to payoff early to save on interest payments.
Structured Credit Products
Extension risk is generally most important to secondary market investors in structured credit products. These products package loans into portfolios that are sold in the secondary market, usually with various tranches representing different types of risk.
Extension risk can be assessed on various types of structured credit products with rate changes having different effects on fixed and variable rate loans. If a structured credit investment is comprised of fixed rate loans in a rising rate environment then extension risk will generally be higher for the investors since borrowers are content with the interest rates they are paying and have less incentive to payoff their loan early. This increases extension risk since investors must wait longer to receive their payments from the loan. Extension risk can also lower the secondary market trading value of a fixed rate structured product in a rising rate environment since general pricing mechanisms will seek to assign greater value to investments paying higher interest rates.
With variable rate products extension risk is lower in rising rate environments. This is because investors have greater incentive to prepay when rates are rising on variable loans creating earlier payoffs to investors. Investors receive prepayment which they can then invest at higher rates as well.