The main risk types in collateral pools are prepayment risk and credit risk.
- Prepayment risk is a type of risk that is associated with loans and loan pools (pooled loans, such as mortgage pools) in the case where borrowers repay a debt obligation before it comes due. This risk arises from early repayment of debt obligations, in part or in full, typically opting for refinancing to take advantage of lower interest rates. In other words, banks and financial institutions can face repayment risk if borrowers are granted the option to take advantage of lower interest rates by refinancing their loans on more favorable terms. Prepayment risk has two main subcategories: contraction risk and extension risk. Prepayment risk leads to specific situations facing lenders, mainly including: cash flows occurring earlier than planned, the loan duration getting shorter than contractually set, and the possible need to reinvest funds at lower interest rates (opportunity cost).
- Credit risk: the risk of default that pooled loans may experience, embodied in the inability of borrowers to pay interest and/ or repay loan principal amounts, whether fully or partially, as per contractual terms.
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