Prepayment Risk and Time Tranching

Prepayment Risk

Prepayment risk pertains to the possibility that the borrower repays the principal differently than the agreed schedule. It includes two facets: contraction risk and extension risk. Borrowers might change their repayment patterns based on changing interest rates. In a falling interest rate environment, borrowers are more likely to refinance their mortgages to capitalize on the lower rates. This is typical in places like the United States, where there are minimal penalties for early repayment. This implies that investors receive their principal back sooner than expected, shortening the term of the MBS. This forces them to invest at the lower, less favorable interest rates. This phenomenon is termed a contractual risk.

Conversely, in a rising interest rate environment, borrowers tend to hold onto their existing mortgages, avoiding refinancing. This situation, known as extension risk, prolongs the repayment period, causing investors to wait longer for their returns. Moreover, the longer duration combined with higher interest rates can diminish the present value of these future cash flows.

Time Tranching

Time tranching in securitizations is a method designed to manage the unpredictability associated with prepayment risk, which arises when borrowers change their repayment patterns. This approach involves creating bond classes with distinct expected maturities to redistribute the prepayment risk among them. For example, using sequential tranching, a securitization pool can be designed such that principal repayments flow to one tranche first until its principal is fully paid off, then move on to the next tranche, and so forth.

Question

Which of the following best describes prepayment risk?

1. The risk that the borrower will pay higher interest than the contractually agreed rate.
2. The risk that the borrower will pay back the principal at a different pace from the contractually agreed schedule.
3. The risk that the borrower will default on the repayments of their loan.

The correct answer is B.

Prepayment risk is the possibility that the borrower repays the principal or a portion of the principal at a different pace than the contractually agreed schedule, either sooner or later than expected.

A is incorrect: Prepayment risk does not deal with interest rates but rather the pace of principal repayments.

C is incorrect: Prepayment risk does not pertain to defaults but to early or delayed principal repayments.