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.
March 17, 2025
