Contraction risk is a type of prepayment risk that is faced by holders of fixed-income securities and other types of arrangements (loans, mortgage loans, etc.) when interest rates decrease, in which case the borrower/ issuer may pay back the principal amount prematurely (earlier than expected), which in turn reduces (contracts) the amount of future interest income that the security holder (lender/ creditor) expected to receive. The debt or debt security will have a shorter maturity than was planned because of early prepayments for refinancing at the new, lower interest rates.

Extension risk 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 comes into play 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).

Both contraction risk and extension risk are types of prepayment risk. Both impact lenders but in different ways: the former reduces (contracts) the amount of interest income that the security holder (lender/ creditor) expected to receive in the future, while the latter reflects slower prepayments due to interest rate rises, where a borrower has less cash flows to reinvest at higher rates. In either situation, the planned cash flows of a lender get negatively impacted either in terms of expected amounts or locked-up principal (and slower repayments).