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Basic Question 1 of 1

Select the correct statement(s).

I. Extension risk is the risk that as interest rates rise, prepayments will slow.
II. Contraction risk refers to the decrease in the interest rate sensitivity of mortgage pass-through securities.

User Contributed Comments 9

User Comment
danlan2 Is II correct?
ianrh I think 2 is incorrect. Contraction risk is if prepayments increase (from lower interest rates).
jangro I do believe it is correct since cashflows speed up=>duration is shorter=>sensitivity drops...or am I wrong?
valeris Agree, II is right - price of the bond doesn't go up as much due to prepayments.
Lavay Duration is the sensitivity of a bond's price to interest rates. During contraction duration drops, which means the sensitivity of the bond's price as interest rates drops also drops. II is correct.
alki The reason for the duration to drop during contraction is the additional payments that come in which lowers the maturity of the security, lower the maturity, the lower will be its duration....
Luke41 average life approximates duration, so as avg life decreases, so will duration
actiger II is correct.
mazen1967 during contraction duration drops ; it is the sensetivity of the bond prices to intrest rate
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I passed! I did not get a chance to tell you before the exam - but your site was excellent. I will definitely take it next year for Level II.
Tamara Schultz

Tamara Schultz

Learning Outcome Statements

define prepayment risk and describe time tranching structures in securitizations and their purpose

CFA® 2024 Level I Curriculum, Volume 4, Module 19.