Question

1. Explain the relationship between interest rate risk and extension risk using a callable bond.

Answer 1

In callable bonds there is an embedded call feature. In case the interest rate falls, the issuer returns back the principal to the investor who is now left with a prepayment risk. The investor now has to invest the money at a, lower rate of interest.

So, interest rate risk in callable bonds is as the interest rate falls there is a n increase in chance that the bonds are called by the issuer leaving the investor with prepayment risk.

Now, extension risk in callable bonds,

When the interest rate rise, the extension risk increases, as the expected maturity of the callable bonds lenghtens which leaves the investor with a lower return . We can solve the problem of extension risk in callable bonds by investing in floating rate bonds. The investors of mortgage backed securities, municipal bonds, fixed preferred securities are exposed to this type of risk.

In extension risk the chances of the bond being called falls down and the bond becomes more dependent on the changing interest rate levels.