Prepayment Risk

[Maximus_FRM2012]

Hi David,

looking over your notes (p.97), it defines prepayment risk as "the risk that the borrower will actually prepay the loan, which can only be replaced by a lower yielding asset". Wouldn't this be the same thing as reinvestment risk (which would be more broad and general since the investor is always facing reinvestment risk after each coupon payment). With prepyament, it just means that the reinvestment risk is greater since there is more cash that has to be reinvested.

Am I missing something?

Maximus

 

[shady007]

Yes. True. Prepayment risk is generally accompanied by reinvestment risk. Becoz prepayments tend to happen when the interest rates are low and we need to invest the principal at a low interest rate. But in case the prepayment happened due to some other reason like forced sale, personal reasons etc. there will not be reinvestment risk.

 

[ShaktiRathore]

Yeah agree shady007
Prepayment Risk occurs when the mortgage holders prepay a large or whole part of the mortgage, thus the MBS holders receive the payment well before the maturity of the mortgage. Generally this prepayment occurs at low interest rates so the MBS holders deposit the prepaid amount at a lower interest rate so as to refinance a new mortgage at a lower rate. So there is always a risk of reinvesting at lower interest rate associated with the prepayment risk in addition to the reinvestment risk associated with regular interest payouts. So reinvestment risk increases.

thanks

 

[shady007]

ShaktiRathore

I would like to make your following statement clearer.
"Generally the prepayment occurs at low interest rates"

The above statement holds good always for fixed interest rate mortgages. For Adjustable rate mortgages, esp. if the adjustment depends on current market interest rate, there will not be any full prepayment by refinancing even if the interest rate decreases drastically. However, curtailment (partial prepayment) is still possible and reinvestment risk is still there but not as much as in case of fixed interest rate mortgages.

 

[Maximus_FRM2012]

Hi everyone,

Thank you for the feedback and clarification.

Maximus