Which of the following is the best definition of extension risk? The adverse consequences of: A) lower prepayment rates. B) declining interest rates on passthrough securities. C) increasing interest rates on passthrough securities. Your answer: A was incorrect. The correct answer was C) increasing interest rates on passthrough securities. I don’t totally get why “a” is wrong. I thought extension risk is when prepayments are lower than what was anticipated?
Prepayments are payments made over the minimum payment so any type of prepayment will not extend the mortgage(passthrough) or whatever loan it is. Increasing interest rates will extend loan amt cause with more interest on the loan it will take longer to reduce the principle value.
a7m002, your explanation really didn’t make sense to me. I would have thought the answer was A as well. I looked it up though. The answer is indeed C, because extension risk involves two things. 1) Rising interest rates leads to you getting money later than planned due to slower prepayments 2) Due to the slower prepayments, you are unable to reinvest as much returns into the higher interest rates Since this risk involves reinvestment and not just timing of prepayments, the answer is C. The books says “The adverse consequence from a rise in interest rates for a passthrough is referred to as extension risk”. It says the opposite about contraction risk.
This is a tricky question…When I first read answer A it looked like the right choice to me as well, though after reading answer C it seemed there were two answers! After thinking about this for a few minutes I concluded that what answer A is really stating is: The prepayment RATE is lower (ie a PSA of 100 rather than a PSA of say 165) and NOT that the actual prepayments are lower than the assumed prepayment rate - which is what causes extention. Just because the assumed rate of prepayment is lower b/w one CMO and a different CMO does not indicate that the CMO with the lower prepayment rate has any more extention risk than the other. Make sense? Keep these types of questions coming though -We all need to see the types of tricks that may pop up on the exam!