A note on prepayment modelling for residential mortgages

By Svetlana Borovkova / December 2017

Banks with mortgage portfolios face the risk of early prepayments of these mortgages. Early prepayments result into substantial interest rate risk, since in this case the duration of the mortgage portfolio becomes stochastic. This can lead to significant mismatches between the expected and actual cashflows, which is shown in the figure below, which depicts the cashflows without and with prepayments on a 100K of a typical 30‐year mortgage portfolio.

With the increased scrutiny that banks face as the result of sharpening IRRBB standards, the proper modelling of the mortgage prepayment risk becomes more and more important. Probability & Partners has a significant expertise in modelling the prepayment risk for Dutch residential mortgages. In this note we briefly review the main prepayment modelling methodologies, main factors affecting prepayment risk and outline some other related issues such as hedging of prepayment risk and the associated model risk.