Prepayment Risk Modelling for ALM, Finance and FTP: A Survival Model

Pierluigi Coriazzi and Lisa Signani

In many jurisdictions, including that of Italy, customers can repay or refund their mortgages without penalty at any time; where penalties apply, prepayment is a less relevant risk. Prepayment risk affects both fixed and floating rate loans, although interest rate risk is minor for the latter compared to the former, for floating rates loans it is not negligible when considering the spread component.

From the financial point of view, a loan/mortgage subjected to early redemption risk is similar to a callable bond issued by the customer and underwritten by the bank: customers should exercise the prepayment option to minimise the present value of their loans. However, option pricing theory can be of limited use in the assessment of prepayment risk, especially for retail loans, as the average financial knowledge of participants is often quite low and the market efficiency theory frequently does not hold. Prepayment also affects floating rate loans where rational exercise arguments are not directly applicable. For these reasons, prepayment estimation is frequently approached through the use of behavioural models.

The graph in Figure 16.1 shows the historical prepayment rate for