Extension Risk

CFA Level II Fixed Income
#1

I am fiinding a hard time understanding a concept related to prepayment risk. It is mentioned in Schweser and the CFA curriculum that extenstion risk is the risk that prepayments will be slower than expected.

However, how is that a risk? If prepayments take longer than expected it is a good thing. Moreover, it is mentioned that if prepayment take longer than expected, the securitiy becomes longer in maturity than anticipated at the time of purchase.

I believe they do not mean prepayments… they actually mean repayments since if no amount was prepaid at all (worst case scenario) the maturity of the security would remain unchanged.

Can someone please clarify if i’m missing something over here?

#2

Keen to know about it too.

Is prepayment the same as repayment? Schweser notes seem to be using both words interchangebly.

#3

Extension risk is not necessarily a good thing. One of the benefits of securitization is to match an investor’s maturity and risk profile. (“Securitization has led to financial innovation that allows investors to invest in securities that match their preferred risk, maturity, and return characteristics” - pg 250 of Alts and Fixed income schweser bk)

Since extension risk results in a longer maturity than the investor signed up for, it is a form of risk.

#4

Prepayment is not the same as repayment.

Prepayment is paying more than the scheduld principal amount, while repayment tends to mean that the borrower is paying the scheduled amount of interest and principal

#5

thanks buddy:)

#6

Calling something a risk doesn’t imply that the outcome is bad. We use standard deviation of returns as a measurement of investment risk, but roughly half of the returns will be above the average. The risk is the uncertainty.

MBSs assume a (positive) level of prepayments. If the actual level differs from the assumed level, the results will be different than anticipated. That’s the risk. Not worse, necessarily, and not necessarily better, just different.