Answer: prepayment risk on mortgage-backed securities.

## 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.

Author: LeetQuiz .