FP Article 15.15
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Investment Risk -
Prepayment Risk
by Rajen Devadason
Ownership often proves more profitable than
loanership for two reasons: Equities have a
higher risk premium than bonds, and they don't
run the risk of being prepaid out of existence
just when things start to get interesting!
Rajen Devadason
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Prepayment risk is a type of
investment risk that can take on
many different shapes and sizes. Let
me explain.
For instance, banks are open to
prepayment risk when homeowners take
advantage of lower costing mortgages
to repay their existing home loans.
Even retail investors aren't spared
exposure to some form of prepayment
risk.
Let's say you
invested in the loan stock of a
company that permits flexible
redemption terms. |
We'll imagine for the sake of this exercise that
you bought 1,000 loan stock of a company known
as Loophole Seeker for $1 apiece. It has, let's
imagine, a coupon rate of 8%.
Initially, you are very happy
with your seemingly safe, secure investment.
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This is an article explaining
prepayment risk. I hope you enjoy
reading it. But if it isn't what
you're looking for, you're welcome
to search for something that better meets
your needs. Thank you for allowing
me to serve you.
Rajen Devadason |
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But let's then suppose that six
months down the road, interest rates start to
fall.
Initially, you would appear to
have reason to celebrate because the
attractiveness of your loan stock has risen;
this should cause its price to rise.
But what if the company's board
of directors then decides that since interest
rates are falling, it would be wiser for the
company to borrow cheaper money from banks and
redeem your loan stock early, at $1.
In such a situation, you would
have suffered a realised prepayment risk.
If you'd like to continue to learn more about
other types of investment risk, here's
additional information for you...
15 Types of Investment Risk
(OR, to sign up for a
FREE
16-lesson eCourse on Investment Risk, please
click here.)
1.
Borrowing Risk
2.
Company Risk
3.
Credit Risk
4.
Currency Risk
5.
Diversification Risk
6.
Industry Risk
7.
Inflation Risk
8.
Interest Rate Risk
9.
Liquidity Risk
10.
Lost Opportunity Risk
11.
Manager's Risk
12.
Market Risk
13.
Market Timing Risk
14.
Political Risk
15. Prepayment Risk
© Rajen Devadason
