The risk that borrowers repay a loan early, usually when rates fall, changing the investor's cash flows. It shortens the life of mortgage securities when reinvestment is least attractive.
Where you will meet it
Prepayment risk comes up in 11 learning outcome notes across the FRM syllabus.
A few of them:
Mortgages and Mortgage-Backed Securities FRM Part I · Financial markets and products
“The single monthly mortality rate, SMM, is the share of the pool's balance that prepays in a month, measured after scheduled principal: SMM = prepayment in the month ÷ (beginning balance − scheduled principal).”
Credit Scoring and Retail Credit Risk Management FRM Part II · Credit risk measurement and management
“Funding long fixed-rate mortgages with short deposits creates interest rate and liquidity risk, prepayment changes the cash flows, fraud and process failures create operational risk, and mis-selling or unfair practice creates conduct, legal and reputational risk.”
The Investment Function in Financial-Services Management FRM Part II · Liquidity and treasury risk measurement and management
“Selection factors are credit quality, marketability, maturity and interest rate risk, call or prepayment risk, tax status, pledging requirements and regulatory liquidity treatment.”
Mortgages and Mortgage-Backed Securities FRM Part I · Financial markets and products
“PAC tranches are protected within a prepayment band by support tranches.”
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