Prepayment Risk Model

Definition

A Prepayment Risk Model is a specialized quantification framework that aims to estimate the range of future realizations of Prepayment in a variety of loan or other fixed income portfolios and thereby help manage Prepayment Risk.

Approaches

There are various approaches to modeling prepayments, depending on the context and use of Model Outputs.

Market Instrument Approach

Prepayment rates are determined in such a way that valuations of prepayment sensitive securities equal the prices observed in the market for such securities. This approach is useful in pricing derivatives. The estimated parameters are Risk Neutral and therefore not directly usable in Risk Measurement.

Option Theoretic Approach

Borrowers are assumed to use optimal exercise strategy of their Prepayment Option. This can be a useful means to generate prepayment estimates in the absence of alternatives. The caveat is that optimal exercise may not describe real behavior.

Empirical or Statistical Approach

Models that aim to estimate prepayments behavior from (macro)economic and potentially other social data on the basis of past (historical) realisations and under the assumption that these behaviors are stable. Within a statistical approach there are further distinct families of models that can be used together or as alternatives

• Portfolio (Pool) based Models
• Prepayment Scoring Models

Model Elements

In general, the following elements might appear in prepayment risk models. The precise manner is model dependent.

• Valuation of contractual terms (cash flows)
• Macroeconomic variables (housing prices, interest rates, economic conditions), both current, historical and forward expectations
• Borrower characteristics (socioeconomic indicators, geographical)
• Seasonality