Prepayment Risk

Definition

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

Causes

Prepayment options are clauses in financial contracts that aim to provide flexibility to one of the parties. The 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.

The disincentives to prepayment vary significantly between jurisdictions.

The risk to the lender is a expressed as the market value loss from moving to the agreed fixed cashflow stream to a replacement stream at the current fixed rates and for equivalent remaining maturity.

Mitigation

Prepayment risk can be reduced with prepayment penalties or other schemes that aim to reduce the value of the prepayment option.

Issues and Challenges

• Contracts with both prepayment and credit risk can complicate risk management
• Securitisations that aim to manage both risk types have complex tranching structures

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