What is the difference between extension risk and contraction risk?
Extention - the risk that and investor will not be able to get back his return within the originally expected time horizon because the cashflows backing the investment are not coming in time or amount as origionally anticipated. if interest rates are rising the investor will have his money tide up and will not be able to benefit by reinvesting in the high inetrest rates contraction risk- the opposite. when there are prepayments, cultailments etc the underlaying cashflows will be repaid too fast than planned. this would happend mostly if inetrest rate are declining and there is an incentive to refinance, and so an investor will have huge amounts of cash flows to reinvest at low interest rates.
extension risk is the risk that obliger cannot repay at the maturity date thus the investor has to wait longer than the original contract time. contracttion risk it the risk that obliger repays much faster than the contract planned so that the investor has to seek other investment chances. the interest rate might be lower than the contract rate, so there is a risk for investor that cannot earn the same return.