A Simple Approach to Modelling Prepayment Events

Matteo Formenti and Mattia Rossi

Prepayment was defined by Kolbe and Zagst (2007) as “a borrower’s decision to exercise an early repayment option in a financial contract”. From a banking point of view, it represents a risk of liquidity, interest rate and, to a limited extent, foreign exchange risk. In particular, prepayment phenomena expose the bank to liquidity risk since the change of maturity profile has a considerable impact on the representation of the available funding sources. For example, an underestimation of prepayment exposes the bank to the risk of overestimating its future liquidity requirements (over-funding), as well as to the risk of increased long-term liquidity costs.

PREPAYMENT EVENTS AND LIQUIDITY AND INTEREST RATE RISK

Prepayment affects interest rate risk since the change in the maturity profile modifies the cashflows exposed to a change in value when interest rates change. As a consequence, the economic value and net interest income (NII) sensitivity will differ when comparing the contractual versus the behavioural profile. As an example, the prepayment of fixed rate loans exposes banks to the risk of overhedging since the real cashflow in the maturity profile will be lower than the one

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