Answer: Commercial mortgage-backed securities with a balloon payment

## Explanation **Extension risk** refers to the risk that the actual maturity of a fixed income security will be longer than expected due to slower prepayments or refinancing activity. This typically occurs when interest rates rise, making refinancing less attractive for borrowers. Let's analyze each option: **A. Commercial mortgage-backed securities with a balloon payment** - **CORRECT** - Commercial mortgage-backed securities (CMBS) with balloon payments have a large lump-sum payment due at maturity. - If borrowers cannot refinance the balloon payment when it comes due (often due to higher interest rates or poor property performance), the loan may need to be extended. - This creates significant extension risk as the security's maturity could be extended substantially if the balloon payment cannot be refinanced. **B. Shorter-term tranches in a collateralized mortgage obligation structure** - **INCORRECT** - Shorter-term tranches in CMOs are designed to have shorter average lives and are less exposed to extension risk. - These tranches receive principal payments first, so they are paid off before longer-term tranches. - They have less sensitivity to changes in prepayment speeds compared to longer-term tranches. **C. Planned amortization class tranches in a collateralized mortgage obligation structure** - **INCORRECT** - PAC tranches are specifically structured to have more stable cash flows and are protected against both extension and contraction risk. - They have a schedule of principal payments that is protected within a certain range of prepayment speeds (the PAC collar). - Only when prepayments fall outside the PAC collar do PAC tranches experience extension risk, and even then, they are less exposed than other tranches. **Key Concept**: Extension risk is greatest for securities where borrowers have the option to extend maturity when market conditions are unfavorable. Balloon payment structures in CMBS are particularly vulnerable because if refinancing is unavailable or too expensive at maturity, the loan must be extended, significantly lengthening the security's duration.

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