Page 72 - FINAL CFA SLIDES DECEMBER 2018 DAY 14

LOS 53.f: Define prepayment risk and Session Unit 15:

describe the prepayment risk of
53. Introduction To Asset-Backed Securities
mortgage-backed securities., p.80

Prepayments are principal repayments in excess of the scheduled principal repayments for
amortizing loans.

Prepayment risk: an important characteristic of pass-through securities; it arises because mortgage
loans used as collateral for agency MBS have no prepayment penalty. It has 2 variants:
• Extension risk: the risk that prepayments will be slower than expected (increases default or

credit risk); and
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• Contraction risk: the risk that prepayments will be more rapid than expected (reduces total

interest over life of the loan).

CFAs must make specific assumptions about prepayment rates in order to value mortgage

pass-through securities. Two approaches are available:

• Single monthly mortality rate (SMM) = the % by which prepayments reduce the month-end

principal balance, compared to what it would have been with only scheduled principal payments
(with no prepayments).

• Conditional prepayment rate (CPR) = an annualized measure of prepayments; these depend on
the weighted average coupon rate of the loan pool, current interest rates, and prior prepayments

of principal