Contraction Risk

Posted in Finance, Accounting and Economics Terms, Total Reads: 472
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Definition: Contraction Risk

It is the risk that is associated with the lender of the debt or the holder of the fixed securities. It deals with the loss that lender will have to face because of the decrease in the duration of the debt cycle. It mainly arises because of the increased chances of prepayment because of the fall of the market rates.


Contraction risk ∝ 1 / Interest Rate

 

Whenever there is a decrease of market interest rest debt instruments become cheaper .Then borrower is allured towards these cheaper instruments and may rush into paying the existing outstanding debt leading to the prepayment .They can do this by getting signing with a new lender at a cheaper rate and then paying off the debt of the debt of the existing lender. This impacts the interest income generated by the borrower negatively and hence creates a risk. The risk is evident in banking industry in which loan forms a big part of their earnings. A borrower could repay the loans leading to huge hit at the bottom-line. So, banks generally used to keep penalties with prepayments which later got abolished by the Reserve Bank of India (RBI)


Suppose SBI gives home loan to a borrower at the rate of 10% with a repayment cycle of 25 years. Now the bank expects to earn throughout these 25 years. In case the interest rates falls to 8% after 10 years, then the lender will no longer find it logical to keep continuing the payment of interest at the rate of 10%. So, what he will try to do is refinance the loan from some other bank and then prepay the loan of SBI or he can increase the frequency or amount of EMI’s to decrease the tenure of the loan. In both these cases SBI will lose out its interest Income. For banks this risk is a considerable parameter as income from lending forms the major part of their balance sheet.

 

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