Fixed rate mortgage with constant annuity is a common and robust asset for a bank or an insurance company. However, such an investment solution is not free of risk: in case of downward movement in interest rates, the mortgagor would be inclined to refinance his loan to obtain a reduced level of monthly installment or a reduced maturity.
The financial opportunity of the retail client represents a plural risk for an ALM department (re-investment risk, over-hedging risk). Since the penalty due to the bank is legally bounded, it cannot compensate entirely the bank for the loss of an expected return (being the series of interest payments initially defined in the amortization scheme of the loan).
As such, this prepayment opportunity is perceived as an embedded option, for which an accurate and realistic value is somehow difficult to handle. The difficulty stands – mainly – in the behavioural aspect of the prepayment activity. A retail customer might be driven by the same incentive as a well-informed financial market participant (profit-seeking), but the force of response and the decision-making timing are clearly different. A mortgage loan is arguably one of the biggest financial contracts one may subscribe in his/her life. In fact, the subscription/prepayment event might belong to more than one client, making the decision-process even more complex to handle. But the profit-seeking logic is not always respected. A prepayment may occur because of social events, which a modelling framework shall consider adequately.
Finalyse proposes a statistical methodology enabling the issuer to capture the prepayment activity on a portfolio of loans, resulting from either profit-seeking or social events.
What benefits can our service bring you?
- Identify the sources of prepayment risk
- Quantify the effect of each source of prepayment risk, through:
- Basic model: portfolio replication
- Advanced model: survival analysis method (estimation of the time-to-event)
- Identify time-frames with higher and unexplained prepayment activity
- Quantify the future expected effect of prepayment activity on a predefined mortgage portfolio
- Establish a correct Fair Value of any mortgage-linked security/asset