11.3 Define Prepayment Rules

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. This difference between the actual and expected cash flows undermines the accuracy of transfer prices generated using cash flow based transfer pricing methods. Consequently, a financial institution needs to predict the prepayment behavior of instruments so that the associated prepayment risk is taken into account while generating transfer rates. Oracle Funds Transfer Pricing allows you to do this through the Prepayment Rule.

A Prepayment Rule contains methodologies to model the prepayment behavior of various amortizing instruments and quantify the associated prepayment risk. For more information, see Defining Transfer Pricing Methodologies.

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

Oracle Funds Transfer Pricing allows you to make use of the node level and conditional assumption while defining prepayment methodologies for your products. For more information, see Associating Node Level and Conditional Assumptions with Prepayment Rules.

Tip:

Prepayment assumptions are used in combination with only the four cash flow based transfer pricing methods: Weighted Term, Duration, Average Life, and Zero Discount Factors.