Contraction Risk Definition

What Is Contraction Risk?

Contraction risk is a type of risk faced by the use of holders of fixed-income securities. It refers to the risk that the debtor might pay once more the money borrowed further in short than anticipated, thereby lowering the amount of long run interest income won by the use of the protection holder. Contraction risk is therefore a component of prepayment risk.

This sort of risk will building up as interest rates decline. It is because declining interest rates might incentivize borrowers to prepay some or all of their remarkable cash owed so as to refinance at lower interest rates.

How Contraction Risk Works

Buyers who gain fixed-income securities are purchasing a flow into of long run interest and foremost expenses from a debtor. As an example, homeowners of mortgage loans are entitled to the expenses made by the use of a homeowner, whilst homeowners of corporate bonds download their expenses from an organization borrower. In each case, the holder of the protection is expecting the borrower to pay them once more continuously over the period of time of the loan—akin to twenty-five years in relation to a 25-year mortgage.

If the borrower were to repay the loan further in short than expected, this creates a topic for the protection holder. It is because the protection holder now should reinvest the repaid loan amount in another investment car. If interest rates have declined given that original loan used to be as soon as given, the investor might not be capable to to find new investments that supply a comparable rate of return. This may end up in the investor receiving a miles much less sexy return than they initially planned for.

For fixed-rate loans, contraction risk usually comes into play in declining interest rate environments, because of borrowers could also be tempted to refinance their loans using the new, lower fees. When fees are rising, however, fixed-rate borrowers will should not have any incentive to prepay on their loans. In relation to variable-rate loans, however, borrowers could also be tempted to prepay early if fees rise or fall. In any case, if fees rise all over the period of time of their loan, they’ll want to spice up up their expenses so as to steer clear of paying higher interest at some point.

Precise Global Example of Contraction Risk

For example, believe a financial status quo that gives a mortgage at an interest rate of 5 %. That financial status quo expects to earn interest on that investment for the 30-year life of the mortgage. Then again, if the interest rate declines to a few %, the borrower would perhaps refinance the loan, or spice up up expenses. This prepayment reduces the selection of years that they will pay interest to the investor. The borrower benefits by the use of doing so because of they’ll ultimately pay a lot much less in interest over the lifespan of the loan. The mortgage owner, however, in the end finally ends up with a lower rate of return than initially expected. 

Contraction risk, which usually takes place when interest rates decline, is the counterpart to extension risk, which maximum ceaselessly takes place when interest rates building up. Whilst contraction risk happens when borrowers pre-pay a loan, shortening its period, extension risk occurs when they do the opposite—they defer loan expenses, increasing the length of the loan.