CHAPTER 5Swap Prepayment Risk

Don't cross a river if it is four feet deep on average.

– Nasim Taleb

WHAT IS SWAP PREPAYMENT RISK?

Prepayment is the unscheduled early repayment of principal on a loan, either in part or in full. Most prepayment is characterised by repayment in full when borrowers refinance their loan with another lender at a more favourable rate or sell the underlying asset that is the subject of the loan. Prepayment risk is the associated risk for the lender generated by that unscheduled early payment. The associated risks are twofold, namely that (i) a lower‐than‐expected profit was made on the loan due to the truncated stream of interest payments; and (ii) when the returned principal is re‐invested in new loans, there is a risk that loan pricing has tightened and margins have fallen. Most lenders attempt to manage prepayment risk via retention strategies, which can include a range of reactive and proactive activities from targeted rate reductions to predictive analytics. In some jurisdictions and asset classes, prepayment penalties may exist and these can have a significant impact on prepayment behaviour.

Prepayment behaviour depends very significantly on the available incentives and disincentives borrowers have available to them. These can vary widely across countries, asset classes and even lenders. In this book, as far as prepayment risk is concerned, we focus solely on loan markets that are predominantly floating rate. This includes residential mortgage ...

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