Contraction / extension risk
CFA Level I Glossary
Contraction and extension risk are the two sides of prepayment risk for mortgage pass-throughs and similar assets. Contraction risk is principal returning too fast when rates fall and homeowners refinance, forcing reinvestment at lower yields. Extension risk is principal returning too slowly when rates rise, leaving you stuck with longer duration at unattractive prices. Holders face this two-sided curse; people often remember only the refinance side.
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