Explain extension and contraction risk, Risk Management

Question 1

(a)  Prepayment refers to paying principal on a security before the due date. Prepayment risk is the risk associated with the early unscheduled return of principal on the mortgage pass-through security. The prepayment risks include two main risks namely extension risk and contraction risk.

Extension risk is the risk of the security lengthening in duration owing to the deceleration of payments. Prepayment delays when the interest rates increase because principal cannot be reinvested as much at higher rates. Extension risk occurs because the average life of return of principal gets extended. Extension can be adverse when security is trading at a discount because it delays reinvestment of principal at higher interest rates. Extension may also be beneficial when security is trading at a premium because it delays reinvestment of principal at lower rates.

Contraction risk is the risk of the security shortening in duration owing to acceleration of payments. Prepayment accelerates when interest rates lower, because upside price potential is restricted and cash flows will be reinvested at lower rates. Contraction risk occurs because the average life of return of principal gets shortened. Contraction can be adverse when security is trading at a premium because of capital loss and reinvestment can be made at lower rates. Contraction can be beneficial when security is trading at a discount because of capital gain and reinvestment can be made at higher rates.

(b)  Tranche I has a higher OAS and lower option cost as compared to Tranche II and the effective durations of the two tranches are equal. Rich and cheap securities are identified by comparing the OAS and option costs of the given tranches in a CMO deal. For a given Z-spread and effective duration, cheap securities will normally have high OAS relative to the required OAS and low option costs and rich securities will have low OAS relative the required OAS and high option costs. Cheap securities are undervalued and hence must be bought and vice versa for rich securities. Here Tranche I is undervalued on a relative basis and Tranche II is overvalued, implying that Tranche I is less expensive as compared to Tranche II. Thus Tranche I must be bought and Tranche II must be sold.

Posted Date: 3/22/2013 5:10:03 AM | Location : United States







Related Discussions:- Explain extension and contraction risk, Assignment Help, Ask Question on Explain extension and contraction risk, Get Answer, Expert's Help, Explain extension and contraction risk Discussions

Write discussion on Explain extension and contraction risk
Your posts are moderated
Related Questions
Explain in detail about the Non-Systematic Risk Variability in a security's total returns not related to overall market variability is termed as the non-systematic (non-mark

I would need a literature review of the market liquidity risk. 1)Basic definitions 2)Literature review - in the context of market microstructure -Importance of market liquidity ris

Q. What is Expected Return on a Portfolio? The Expected Return on a Portfolio is simply' the weighted average of the expected returns of the individual securities in the given

Question: A safe system of work is a formal procedure which results from a systematic examination of a task in order to identify all the hazards and assess the risks with a vie

Question: XYZ Textiles Ltd manufactures high quality value added knitted garments at its premises in the Industrial Zone in Plaine lauzun. XYZ has a daily capacity of 10 000 pi

The investor has constant wealth 1 and is offered to invest in shares of a project that either gains 3/2 or loses 1 with equal probabilities. Therefore, if the investor obtains sha

Explain the Risk management strategies Retain the risk If risk is small and won't affect company's profits, company does very little and lives with i

what is ripples?

policies for non-cash generating assets

What is Systematic Risk Variability in a security's total returns which is directly associated with overall  movements  in  the  general  market  or  economy  is  known as syst