rates decline. How- ever, for a passthrough security with an embedded prepayment option, the rise in price will not be as large as that of an option-free bond because a drop in interest rates will give the borrower an incentive to prepay the loan and refinance at a lower rate. In other words, the borrower is alter- ing the mortgages flows (i.e., exercising the prepayment option) when this action enhances his/her economic value. Thus, the upside price potential of a passthrough security is truncated because of prepayments in a manner similar to that of a callable bond. The second adverse conse- quence is that the cash flows must be reinvested at a lower rate. These two adverse consequences when mortgage rates decline are referred to as contraction risk. In essence, contraction risk is all the consequences resulting from borrowers prepaying at a faster rate than anticipated. Now lets look at what happens if mortgage rates rise to 10.5%. The price of the passthrough, like the price of any bond, will decline. But again it will decline more because the higher rates will tend to slow down the rate of prepayment, in effect increasing the amount invested at the coupon rate, which is lower than the market rate. Prepayments will slow down because homeowners will not refinance or partially prepay their mortgages when mortgage rates are higher than the contract rate of 8.5%. Of course, this is just the time when investors want prepay- ments to speed up so that they can reinvest the prepayments at the higher market interest rate. This adverse consequence of rising mortgage     rates is called extension risk and results from borrowers prepaying at a slower rate than anticipated. Therefore, prepayment risk encompasses contraction risk and extension risk. Prepayment risk makes passthrough securities unattrac- tive for certain individuals and financial institutions to hold for pur- poses of accomplishing their investment objectives. Some individuals and institutional investors such as cash managers and managers of short-duration portfolios are concerned with extension risk and others with contraction risk when they purchase a passthrough security. Is it possible to alter the cash flows of a mortgage passthrough security so as to reduce the contraction risk or extension risk for institutional inves- tors? This can be done as we will see in the next section.       COLLATERALIZED MORTGAGE OBLIGATIONS   Now we will see how mortgage passthroughs securities backed by fixed- rate mortgage loans with a long WAM can be used to create a structure called a collateralized mortgage obligation (CMO). Two types of bond classes that can be created within the structure is a floating-rate bond