For a mortgage passthrough security, which of the following risks most likely increases as interest rates decline?
A. Balloon.
B. Extension.
C. Contraction.
C is correct. When interest rates decline, a passthrough security is subject to contraction risk. Contraction risk is the risk that the security will be shorter in maturity than was anticipated when the security was purchased due to higher than expected prepayments (which typically occurs when interest rates decline). Extension risk is the risk that when interest rates rise, there are fewer prepay?ments and, as a result, the security becomes longer in maturity than anticipated at the time of purchase. Balloon risk (common with commercial mortgage- backed securities), a type of extension risk, is the risk that a borrower will not be able to make the balloon payment when due.
A is incorrect because balloon risk is a type of extension risk. A passthrough security is subject to extension risk when interest rates rise (not decline).
B is incorrect because extension risk is the risk that when interest rates rise (not decline), there are fewer prepayments and, as a result, the security becomes lon?ger in maturity than anticipated at the time of purchase.