Extension Risk

What Is Extension Risk?

Extension risk is the possibility that borrowers will concede prepayments due to market conditions.

Understanding Extension Risk

Extension risk is generally a concern in secondary market, structured-credit product investments. For example, rising interest rates could deter homeowners from refinancing their mortgages, which reduces prepayment flows. That expands the duration of the loans in a mortgage backed security (MBS) past what the valuation and risk models initially anticipated.

Basically, extension risk is the likelihood that borrowers stay in their loan longer than investors would like, since this concedes the average payment cycle for secondary market product investors. In the primary market, lenders are basically centered around contraction risk (otherwise called prepayment risk) which is the risk that a borrower will pay early and subsequently reduce the interest paid to a lender over the life of a loan.

Primary Market Contraction Risk

Primary market lenders issue loans to borrowers with the expectations that the borrower won't prepay early which diminishes the interest a lender procures on a loan. A few lenders even institute prepayment fees for early payoff to offset losses. With a fixed rate loan borrowers have greater incentive to pay off their loan, explicitly according to a refinancing point of view, when rates are falling. This causes contraction risk for primary lenders since additional borrowers are probably going to prepay.

With variable rate loans primary market borrowers will see higher prepayment when rates are rising which likewise increments contraction risk. At the point when rates rise borrowers have greater incentive to payoff right on time to save money on interest payments.

Structured Credit Products

Extension risk is generally important to secondary market investors in structured credit products. These products package loans into portfolios that are sold in the secondary market, ordinarily with different tranches addressing various types of risk.

Extension risk can be assessed on different types of structured credit products with rate changes diversely affecting fixed and variable rate loans. On the off chance that 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. This is on the grounds that borrowers are happy with the interest rates they're paying and have less incentive to early pay off their loan.

This increments extension risk since investors must stand by longer to receive their payments from the loan. Extension risk can likewise bring down the secondary market trading value of a fixed-rate structured product in a rising rate environment. This is due to the way that general pricing systems will try to assign greater value to investments paying higher interest rates.

With variable rate products, extension risk is lower in rising rate environments. This is on the grounds that investors have greater incentive to prepay when rates are rising on variable loans making prior payoffs to investors. Investors receive prepayment which they can then invest at higher rates too.

Features

• In the primary credit market, prepayment risk is the bigger concern for issuers.
• Extension risk is generally a concern in the secondary credit market.
• Extension risk is the peril that borrowers will concede prepayments due to market conditions.