Contraction Risk

What Is Contraction Risk?

Contraction risk is a type of risk looked by holders of fixed-income securities. It alludes to the risk that the debtor could pay back the money borrowed more rapidly than anticipated, in this way decreasing the amount of future interest income received by the security holder. Contraction risk is in this manner a part of prepayment risk.

This type of risk increases as interest rates decline. This is on the grounds that declining interest rates could boost borrowers to prepay some or each of their outstanding obligations to refinance at lower interest rates.

How Contraction Risk Works

Investors who purchase fixed-income securities are purchasing a surge of future interest and principal payments from a debtor. For example, owners of mortgage loans are qualified for the payments made by a homeowner, while owners of corporate bonds receive their payments from a corporate borrower. Regardless, the holder of the security is anticipating that the borrower should pay them back steadily over the term of the loan —, for example, 25 years on account of a 25-year mortgage.

In the event that the borrower were to repay the loan surprisingly rapidly, this makes a problem for the security holder. This is on the grounds that the security holder presently must reinvest the reimbursed loan amount in some other investment vehicle. Assuming that interest rates have declined since the original loan was given, the investor probably won't have the option to track down new investments that offer a comparable rate of return. This can lead to the investor getting a less alluring return than they initially anticipated.

For fixed-rate loans, contraction risk normally becomes an integral factor in declining interest rate conditions, since borrowers might be enticed to refinance their loans utilizing the new, lower rates. At the point when rates are rising, in any case, fixed-rate borrowers will have no incentive to prepay on their loans. On account of variable-rate loans, be that as it may, borrowers might be enticed to prepay early assuming that rates rise or fall. All things considered, on the off chance that rates rise during the term of their loan, they might wish to accelerate their payments to try not to pay higher interest from now on.

Real World Example of Contraction Risk

To illustrate, consider a financial institution that offers a mortgage at an interest rate of 5 percent. That financial institution hopes to earn interest on that investment for the 30-year life of the mortgage. Nonetheless, in the event that the interest rate declines to 3 percent, the borrower might refinance the loan, or accelerate payments. This prepayment decreases the number of years that they will pay interest to the investor. The borrower benefits thusly on the grounds that they will at last pay less in interest over the lifespan of the loan. The mortgage owner, notwithstanding, winds up with a lower rate of return than initially expected.

Contraction risk, which normally happens when interest rates decline, is the partner to extension risk, which typically happens when interest rates increase. Though contraction risk happens when borrowers pre-pay a loan, shortening its duration, extension risk happens when they do the inverse — they concede loan payments, expanding the length of the loan.

Features

• Such prepayments can hurt investors by denying them of their expected interest incomes.
• Contraction risk alludes to the risk that a borrower will repay their obligations ahead of schedule.
• This would lead to the term of the loan being surprisingly short.