Explain extension and contraction risk, Risk Management

Assignment Help:

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.


Related Discussions:- Explain extension and contraction risk

Determine the optimum prices and outputs, The basic question in this case i...

The basic question in this case is whether Jetliners and Acme Airline should work together to develop a new super sized airframe or should each company seek to develop its own vers

Enumerate about the purchasing power risk, Enumerate about the Purchasing P...

Enumerate about the Purchasing Power Risk A factor affecting all securities is purchasing power risk, also termed as inflation risk. With uncertain inflation, real (inflatio

Display screen equipment risk assessment, Question 1: (a) Describe the ...

Question 1: (a) Describe the aspects that should be considered when assessing the fit between a person and his work. (b) Display Screen Equipment (DSE) risk assessment shoul

Requirement of relevant control of iso, Question: For each of the situa...

Question: For each of the situations below:- (a) Mention most relevant clause of ISO 27001:2005 (b) Whether the practice followed in the organization is appropriate and i

Budget and value report, A strategy value assessment, based on calculating ...

A strategy value assessment, based on calculating the budget of the project. Discussion should not restrict itself to construction cost control but should consider the life cycle a

Determine about the bull-bear market risk, Bull-Bear Market Risk Thi...

Bull-Bear Market Risk This risk arises from the variability in the market returns resulting from alternating bull and bear market forces. Ø when security index rises fair

What are the main causes of risks in a project, Quesiton: (a) Describe ...

Quesiton: (a) Describe why people management is important for the success of a project (b) Show which people and groups of people are important for the success of a project

Define value at risk as a measure of market risk, Black Rock Investors is ...

Black Rock Investors is managing the pension fund of Virgin Atlantic. Sir Richard Branson wants to assess the risk of the portfolio following the Euro crisis. During a discussion

What is the straight value of the convertible bond, The current stock price...

The current stock price of IOU is $250 and has a standard deviation of 35% per year. The risk-free interest rate is 5% per year compounded continuously. Find the prices of a call a

LIability risk, Michael went deer hunting with Ed. After seeing bushes move...

Michael went deer hunting with Ed. After seeing bushes move, Michael quickly fired his rifle at what he thought was a deer. However, Ed caused the move- ment in the bushes and was

Write Your Message!

Captcha
Free Assignment Quote

Assured A++ Grade

Get guaranteed satisfaction & time on delivery in every assignment order you paid with us! We ensure premium quality solution document along with free turntin report!

All rights reserved! Copyrights ©2019-2020 ExpertsMind IT Educational Pvt Ltd