Extension Risk....

The following statements are from CFAI eoc explanations. With Fannie mae PAC issue with an average life of 2 yrs the manager is buying a shorter term security and one with some protection against extension risk. In contrast,the fannie mae passthrough with an avg WM of 310 months , the manager is buying a longer term life security which will expose him with greater extension risk… i dont get this at all….any sort of explanation would be great…

I am assuming you understand the concept of the PAC. So with a passthrough security there is no protection against extension risk, meaning that if interest rates go up, no one refinances their mortgages, and the cash flows will be extended.

Alternatively, with a PAC issue, if the interest rates go up, some of the payments directed towards the support tranches will be redirected towards the PAC investors, so they will avoid possible cash flow extension.

Thanks CFAMixer…i understood it…

the only thing that confused me was the average life given of 2 yrs and 310 months…does avg life have any relevance here ie long term and short time perspective becoz i think that for a short term investor there is extension risk but for a long term investor there is only contraction risk…

I think the life estimates are there to convey the difference between a short term life and longer term life. And any prepayment risk will be benchmarked against those lives (e.g, is the security longer or shorter then 2 years or 310 months).

Can u elaborate…i am still not getting this

Do you mind restating your question? I don’t quite follow which part you need help with.


It really depends. A pass through security offers no protection to both contraction nor extension risk. It really depends on how fast the pre-payment of the mortgages are i.e, the overall direction in mortgage rates.

In general, the longer duration pass-throughs will have more extension/contraction risk simply because there’s more time for uncertain events to occur.

A PAC CMO offers some protection to both extension/contraction risk but does not elimate either. The risk/age relationship remains the same, the longer the duartion, the more time for uncertain events to occur but is lessened by the nature of the PAC tranches.

Dont you all think that the question itself is wrong…ie.

In contrast,the fannie mae passthrough with an avg WM of 310 months , the manager is buying a longer term life security which will expose him with greater CONTRACTION RISK…as i assume 310 months is a long term term so there is no extensive risk for the investor…the risk for the investor is only contraction risk here…

i know that what i am thinking or what is understood is wrong…becoz this is a CFAI EOC answer …and the answer has to be extension risk but any help is extremely needed

Also a passthrough security has extension and contraction risk but it depends on the avg life of the bond…longer term term has no extension risk and shorter term bonds has no contraction risk

please correct me…

Dont confuse yourself.

Any security with a PAC schedule will protect you from both contraction and extension risks.

While a passthrough security will expose you to both higher contracion and extension risks.

As an investor, when you buy a short term security, you show more concerns about extension risks (as you try to avoid $ being locked up).

Ok guys…i now get it…

this is what i get it…

any passthru issue will have a contraction and extension risk irrespective of their life whereas a pac issue will the the investor protection against extension and contraction irrespective of avg life…hence a PAC bond always a better investment

@Galli ,cgy and ro424 and CFAmixer for ur efforts and i am extremely thankful to y’all

will the duration a determinant of extention/ contraction risk?

what if we compare PAC (WAM of 310 months) vs Passthrough (average life of 2 years.)?

Can WAM of 310 months be converted into 25.8 years when compare with the average life?

pls correct me…! thks.