Explanation

Contraction risk and extension risk are two types of prepayment risk that are specifically associated with mortgage-backed securities (MBS).

Key Concepts:

1. Prepayment Risk: The risk that borrowers will pay off their mortgages earlier than expected, which affects the cash flows and duration of MBS.

2. Contraction Risk:

   • Occurs when interest rates fall and homeowners refinance their mortgages at lower rates
   • Results in faster prepayments than expected
   • Investors receive their principal back sooner than anticipated
   • Investors must reinvest at lower prevailing interest rates
   • Shortens the effective duration of the security

3. Extension Risk:

   • Occurs when interest rates rise and homeowners are less likely to refinance
   • Results in slower prepayments than expected
   • Investors' money remains invested longer than anticipated
   • Investors are locked into lower-yielding securities when market rates are higher
   • Lengthens the effective duration of the security

Why Other Options are Incorrect:

• Option A (credit risk on asset-backed securities): While ABS have credit risk, contraction/extension risks are specifically prepayment risks, not credit risks.
• Option C (income risk on commercial mortgage-backed securities): CMBS have different risk characteristics, and while they may have prepayment risk, the terms "contraction risk" and "extension risk" are most specifically associated with residential MBS prepayment risk.

Investment Implications:

These risks are particularly important for:

• Investors who need to match liabilities with specific durations
• Portfolio managers managing interest rate risk
• Investors concerned with reinvestment risk

The correct answer is B because contraction and extension risks are the two components of prepayment risk in mortgage-backed securities.