Prepayment Risk

Definition

Prepayment Risk (also early redemption or refinancing) denotes the risk that clients or counterparties will exercise contractual options to repay funds received earlier than expected

The risk to the lender is expressed as the market value loss from moving from the agreed fixed cashflow stream to a replacement stream at the current fixed rates and for equivalent remaining maturity. Prepayment risk can also be considered a form of Reinvestment Risk.

Taxonomy

In the context of the Open Risk Taxonomy prepayment risk falls under. Within prepayment risk one can recognize sub-categories either on the basis of the type of prepayment or the motivation

• Curtailment
• Refinancing
• Relocation

Causes

A Prepayment Option is a clause in financial contracts that aims to provide flexibility to one of the parties. A typical reason to prepay a loan is when improved circumstances in the internal (e.g., improved credit position) or external factors (lower available interest rates) of the client make it financially attactive to redeem the loan ahead of its nominal life. This is normally the case when product involves a fixed rate that has been set at inception. Other reasons may be relocation or other change in circumstances (e.g. family status).

The disincentives to prepayment vary significantly between jurisdictions and are typically contractual penalty clauses inserted in the credit contract.

Measurement

Prepayment risk can be quantified using a range of possible prepayment risk models that utilize different sources of data and make different model assumptions.

Mitigation

• Prepayment risk can be reduced ex-ante with prepayment penalties or other schemes that aim to reduce the value of the prepayment option
• Ex-post, prepayment risk may be hedged with specialized interest rate derivatives

Issues and Challenges

• Contracts that embed significant prepayment and Credit Risk can complicate risk management (see Competing Risks
• Securitisations that aim to manage both risk types have complex tranching structures