what types of risks are included in the price calculation of bonds? Do we include prepayment risk in price calculation of bonds? What way prepayment risk affects the bond prices?
Prepayment is the amount paid by the issuers to the bondholders in addition to to normal interest and principal payments…Prepayment risk is risk faced by bondholders that issuers will pay them more principal payment when interest goes down thereby exposing the bondholders to risk that they will have to invest that money at lower rates…Hence when issuers embed this option in the indenture, they offer a higher yield and thus the bond price is less as compared to a bond with no embedded options…
Prepayment: If you are bondholder and suddenly receive prepayment on your bond when market interest rates are lower than the coupon you are receiving. You have to reinvest at a lower coupon. That is prepayment risk. If a bond has a prepayment feature then it must pay a higher coupon.