Prepayment Risk

AAA

DEFINITION of 'Prepayment Risk'

The risk associated with the early unscheduled return of principal on a fixed-income security. Some fixed-income securities, such as mortgage-backed securities, have embedded call options which may be exercised by the issuer, or in the case of a mortgage-backed security, the borrower.

The yield-to-maturity of such securities cannot be known for certain at the time of purchase since the cash flows are not known. When principal is returned early, future interest payments will not be paid on that part of the principal. If the bond was purchased at a premium (a price greater than 100) the bond's yield will be less than what was estimated at the time of purchase.

INVESTOPEDIA EXPLAINS 'Prepayment Risk'

For a bond with an embedded call option, the higher a bond's interest rate relative to current interest rates, the higher the prepayment risk.

For example, on a mortgage-backed security, the higher the interest rate relative to current interest rates, the higher the probability that the underlying mortgages will be refinanced. Investors who pay a premium for a callable bond with a high interest rate take on prepayment risk. In addition to being highly correlated with falling interest rates, mortgage prepayments are highly correlated with rising home values, as rising home values provide incentive for borrowers to trade up in homes or use cash-out refinances, both leading to mortgage prepayments.

RELATED TERMS
  1. Constant Percent Prepayment

    Annualized estimate of mortgage loan prepayments, computed by ...
  2. Sequential Pay CMO

    A type of collateralized mortgage obligation (CMO) in which there ...
  3. Contraction Risk

    The risk faced by the holder of a fixed income security when ...
  4. Extension Risk

    The risk of a security's expected maturity lengthening in duration ...
  5. Refinancing Risk

    1. The risk that an early unscheduled repayment of principal ...
  6. Planned Amortization Class (PAC) ...

    A class of tranche in a planned amortization class (PAC) bond ...
RELATED FAQS
  1. What is a Ginnie Mae security?

    A Ginnie Mae, or Government National Mortgage Association security, functions similarly to the process of lending someone ... Read Full Answer >>
  2. How does the term 'in the money' describe the moneyness of an option?

    In options trading, the term "moneyness" refers to the relationship between an option contract's strike price and the current ... Read Full Answer >>
  3. What is the difference between in the money and out of the money?

    In options trading, the difference between "in the money" and "out of the money" is a matter of the strike price's position ... Read Full Answer >>
  4. If a long call is owned on the record date of a stock, is the owner of the option ...

    The owner of a long call for a stock is entitled to a dividend only if the option is exercised prior to the ex-dividend date, ... Read Full Answer >>
  5. How can an investor profit from the cyclical nature of the electronics sector?

    An investor can profit from the cyclical nature of the electronics sector in two ways. He can employ sector rotation, shifting ... Read Full Answer >>
  6. What does negative vega mean for credit spreads?

    Greek vega measures an option's sensitivity with respect to a change in the underlying asset's volatility. The vega of an ... Read Full Answer >>
Related Articles
  1. Bonds & Fixed Income

    Profit From Mortgage Debt With MBS

    Mortgage-backed securities can offer monthly income, a fixed interest rate and even government backing.
  2. Bonds & Fixed Income

    Asset Allocation In A Bond Portfolio

    An investor's fixed-income portfolio can easily beat the average bond fund. Learn how and why!
  3. Bonds & Fixed Income

    The Risks Of Mortgage-Backed Securities

    Find out how weighted average life guards against prepayment risk.
  4. Options & Futures

    SEC-Regulated Options Brokers

    Investopedia provides a List Of SEC-Regulated Options Brokers
  5. Forex

    Best Ways To Protect Your Bitcoins

    Just like any other valuable asset, its important to keep your bitcoins safe. Here are few ways to protect bitcoins from threats like computer failures, loss of passwords, and hackers.
  6. Forex

    10 Cities Leading Bitcoin Adoption

    An overview of the global cities leading the way in using the virtual currency Bitcoin.
  7. Forex

    Beware of these Five Bitcoin Scams

    We look at five bitcoin scams and how to protect yourself from fraud.
  8. Credit & Loans

    Is it Worth Saving Up for a Bigger Down Payment?

    There are numerous low-down-payment mortgage options out there, but sometimes it makes sense to build up your savings so you can borrow less.
  9. Options & Futures

    How To Trade Orange Juice Options

    How do orange juice options work and which factors determine the orange juice valuations? Here's a sneak peak into the world of orange juice options.
  10. Investing

    Bitcoin Vs. Litecoin: What's The Difference?

    Litecoin is often referred to as "the silver to Bitcoin's gold." But what is Litecoin, and how does it compare to its more famous counterpart?

You May Also Like

Hot Definitions
  1. Geometric Mean

    The average of a set of products, the calculation of which is commonly used to determine the performance results of an investment ...
  2. Fisher Effect

    An economic theory proposed by economist Irving Fisher that describes the relationship between inflation and both real and ...
  3. Fiduciary

    1. A person legally appointed and authorized to hold assets in trust for another person. The fiduciary manages the assets ...
  4. Expected Return

    The amount one would anticipate receiving on an investment that has various known or expected rates of return. For example, ...
  5. Carrying Value

    An accounting measure of value, where the value of an asset or a company is based on the figures in the company's balance ...
  6. Capital Account

    A national account that shows the net change in asset ownership for a nation. The capital account is the net result of public ...
Trading Center