Prepayment
Borrowers repaying a mortgage early, overwhelmingly when rates fall. The homeowner holds the option and the investor is on the other side of it.
Where you will meet it
Prepayment appears in 8 learning outcomes on the CFA syllabus. A few of them:
- Explain effective duration and the cases that require it
“Because the option changes the cash flows, effective duration can be far below modified duration, and for a mortgage security it can even turn negative when prepayments accelerate.”
- Explain how a Monte Carlo simulation of forward rates works and where it is applied
“Cash flows are projected along each path, which suits path-dependent securities such as mortgage-backed securities whose prepayments depend on past rates, and discounted at that path's rates.”
- Explain how structured products can stand in for corporate bonds in a credit portfolio
“MBS add prepayment risk and negative convexity, making them effectively short volatility.”
- Explain how private market deals are funded with high-yield bonds, leveraged loans and convertible debt, and why each is chosen
“Choose among them on cost, prepayment flexibility, covenant tightness and the size of the deal.”
Practise it
Practise prepayment until it is automatic: questions that explain every wrong option.
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