Early amoritzation trigger protects the investor against declines in the credit quality of ther underlying receivables. The most common trigger is when the 3-month average excess spread earned on the receivables declines to zero. Hence, an early amortization trigger provision creats the potential of contraction risk in a receivables- backed security. ----> I DONT UNDERSTAND: IF THE CREDIT QUALITY OF THE UNDERLYING RECEIVABLES IS DECLINING, WHY SHOULD THERE BE ANY CONTRACTION RISK??
There would be contraction risk because since the occurrence of credit event (default) would cause cash flows to stop coming in…
Delayed payment (or inability to pay) would cause extension risk (not contraction). Hence an early amortisation trigger preempts this and causes cash flows to come in earlier to protect the investor. Potential for earlier cashflows --> contraction risk.
Agreed, but if there is default… The payment are not delayed… They would be stripped out thus causing contraction risk… I do agree that if it is just a delay in cash flows (ie. Problems paying) then you would have extension risk
Early amoritzation trigger occurs before default. eg. (given in the statement above: 3-month average excess spread earned on the receivables declines to zero) this question doesnt even get to default stage. Once it defaults, I agree that the payments ‘stop’ (asset liquidation, recovery based on Loss given default built in pricing etc.) the statement is simply “early amortization trigger provision creates the POTENTIAL of contraction risk” since a trigger would cause ur cash flows to be received earlier
Got it…echai thanks for the explanation