The risk that arises during periods of rising interest rates when borrowers tend to pay off their loans later than scheduled. It is a type of prepayment risk (in addition to a contraction risk) that when interest rates rise, borrowers may hold on prepayments in reluctance to give up the benefits of a contractual interest rate that has turned low under current market conditions.
Extension risk reflects slower prepayments due to interest rate rises, where a borrower has less cash flows to reinvest at higher rates, and the downside price potential is worsened by negative convexity. Slower prepayments result in a situation where more principal outstanding is invested at below-market interest rates (a coupon rate lower than market rates).
In relation to mortgage loans and similar types of debt, an extension risk constitutes the adverse consequence of increasing mortgage rates.
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