prepayment risk

prepayment risk

The risk to a lender that part or all of the principal of a loan will be paid prior to the scheduled maturity. For a bondholder, prepayment risk refers to the possibility the issuer will redeem a callable bond prior to maturity. Prepayments generally occur when market rates of interest decline following the loan origination. Prepayment generally results in reduced cash flow for a bondholder when proceeds from the redemption are reinvested at a reduced interest rate. Also called call risk.

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Prepayment Risk

The risk that a borrower will repay a loan before its maturity, depriving the lender of future interest payments. Prepayment risk is most important for callable bonds ? in which the issuer may repay the principal and cease paying coupons after a certain date ? and mortgage-backed securities, in which the mortgage holder may refinance his/her mortgage, which will result in the security holder losing future interest. Some callable bonds and mortgage-backed securities have structures embedded within them to reduce prepayment risk. See also: Collateralized mortgage obligation, Yield-to-worst, Yield-to-maturity.

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prepayment risk

See option risk.