Cash Flows and Prepayment Risk
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Prepayment risk is the risk that a borrower will repay the mortgage before its due date. Mortgages can usually be prepaid at any time without penalty.
Two Types of Prepayment Risk
- Contraction Risk: This is the risk that the investor (holder of the fixed income security) is forced to re-invest for a lower return following refinancing of mortgages in response to declining interest rates. The contraction risk increases as the interest rates decline. This is because as interest rates decline, the prepayments increase.
- Extension Risk: Inability of an investor to re-invest principal at higher rates following pro-longed rising interest rates because mortgage borrowers opt not to refinance (which extends the average life of mortgages in the asset pool). When interest rates are rising, the borrowers are less likely to prepay. So, the investor's capital is locked in the securities at a lower rate and they cannot invest this capital in higher-interest instruments.
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