8.13 Defining Prepayments

One of the major business risks faced by financial institutions engaged in the business of lending is prepayment risk. Prepayment risk is the possibility that borrowers might choose to repay part or all of their loan obligations before the scheduled due dates. Prepayments can be made by either accelerating principal payments or refinancing.

Prepayments cause the actual cash flows from a loan to a financial institution to be different from the cash flow schedule drawn at the time of loan origination.

A Prepayment Rule contains methodologies to model the prepayment behavior of various amortizing instruments and quantify the associated prepayment risk.

Prepayment methodologies are associated with the product-currency combinations within the Prepayment rule. For more information, see the Defining Prepayments section.