What type of risk does Prepayment Risk refer to?

Prepayment Risk specifically pertains to the likelihood that borrowers will pay off their loans or mortgages earlier than anticipated. This can happen for various reasons, such as refinancing when interest rates decrease or selling a property before the expected terms of the loan are met. When prepayment occurs, lenders and investors may face a loss of expected interest income, as they receive their principal back sooner than planned, which can be particularly impactful in fixed-income investments like mortgage-backed securities.

The key aspect of Prepayment Risk is its timing unpredictability, which directly affects cash flow projections and overall investment yield. Hence, understanding this risk is essential for effective portfolio management, especially in the context of fixed-rate securities, where the expected return may be significantly altered by unanticipated prepayment behavior.