Difference between revisions of "Prepayment Risk"
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== Definition == | == Definition == | ||
| − | '''Prepayment Risk''' (also early redemption) denotes the risk that clients or counterparties will exercise options to repay funds received earlier than expected <ref>Mortgage Banking, Comptroller's Handbook, 1998</ref> | + | '''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 <ref>Mortgage Banking, Comptroller's Handbook, 1998</ref> |
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| + | 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. | ||
== Causes == | == Causes == | ||
| − | Prepayment | + | 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). |
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| − | The | + | The disincentives to prepayment vary significantly between jurisdictions and are typically contractual penalty clauses inserted in the credit contract. |
=== Mitigation === | === Mitigation === | ||
| − | Prepayment risk can be reduced with prepayment penalties or other schemes that aim to reduce the value of the prepayment option | + | * 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 == | == Issues and Challenges == | ||
| − | * Contracts | + | * 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 | * Securitisations that aim to manage both risk types have complex tranching structures | ||
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<references/> | <references/> | ||
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[[Category:Optionality Risk]] | [[Category:Optionality Risk]] | ||
[[Category:ALM]] | [[Category:ALM]] | ||
[[Category:Risk Elements]] | [[Category:Risk Elements]] | ||
Revision as of 15:33, 1 December 2022
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 [1]
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.
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.
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
References
- ↑ Mortgage Banking, Comptroller's Handbook, 1998
