Question-21: What do you mean by contraction risk in case of MBS?

Answer: The risk that homeowners (who took the loan) can prepay all or part of their mortgage when interest rates decline or their earning increases. That is called contraction risk.

Question-22: What do you mean by extension risk in case of MBS?

Answer: It is also possible that prepayments will slow down when mortgage interest rates rise and as an investor you want that the pool of mortgages would prepay at a faster rate, and you can re-invest this prepaid money somewhere else to get more return/yield, that is called extension risk.

Question-23: What is the credit risk on the bonds?

Answer: Following two are the credit risk on the bonds.

• The risk that the issuer will default on its obligation i.e. default risk.
• The risk that the bond’s value will decline and/or the bond’s price performance will be worse than that of other bonds against which the investor is compared.

Question-24: Why as an investor you expect more price when there is a default risk possibility?

Answer:  Because following one of the reasons

• Higher Spread: The market requires a higher spread due to a perceived increase in the risk that the issuer will default.
• Bond Ratings: Companies that assign ratings to bonds will lower a bond’s rating.

Question-25: What do you mean by credit-spread-risk?

Answer: When there is a default risk on the bond, then there is more spread expected or the credit-spread demanded by the market, that is referred to as credit-spread risk. Like market require more spread in the bond which has default risk.