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
Case: You are a partner in a first time PE fund. Against all chances, you have been able to raise $300M from investors. The business plan based on which you got the funds from

Q. What is Material Safety Data Sheet ? 1. Material Safety Data Sheet is a formal document containing important information about the characteristics and actual or potential ha

Question: You work in one of the major commercial banks of the island and your institution is contemplating venturing into Internet banking in the near future. As the risk m

This assignment asks to investigate an incident at work focussing on risk identification and assessment. The investigative tool that was used was downloaded from the WorkCover webs

policies for non-cash generating assets

Question 1: (i) Define the following by giving an example: (a) Systemic risk (b) Diversifiable risk (ii) List and describe briefly the different types of ri

Question: (a) The site engineer of a building and civil engineering company, employing one hundred and ten employees on a five-storey building project, has decided to carry ou

Question: (a) What are the two major types of risk analysis? (b) Which type is generally used in risk analysis of information systems and why? (c) Explain the methodology

Determine about the Market Risk Variability in a security's returns resulting from fluctuation in aggregate market is called market risk. Market risk is sometimes used synon

Question 1: (a) List ten principles of sensible risk management. (b) There is a legal duty for employers to prevent ill-health which can be caused by work. Describe the step