From a lender's perspective, balloon risk can best be described as a type of:
A extension risk.
B contraction risk.
C interest rate risk.
solution:A
A is correct. From a lender's perspective, balloon risk refers to the risk that a borrower will not be able to make the balloon payment when due. Since the term of the loan will be extended by the lender during the workout period, bal?loon risk is a type of extension risk. Extension risk is the undesired lengthening in the expected life of a security.
B is incorrect because balloon risk is a type of extension (not contraction) risk. Contraction risk would be the risk that the security will be shorter in maturity than was anticipated when the security was purchased.
C is incorrect because, from the lender's perpective, balloon risk relates to the undesired lengthening in the expected life of the security (extension risk). A borrower (not the lender) may face interest rate risk if planning to refinance the balloon amount on the balloon payment date. The interest rate on a new loan to refinance the balloon balance on the balloon payment date is unknown, and thus the borrower is exposed to interest rate risk.
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