Question 6-C 2007 Insurance Company Prepayment Risk

So This is relative to the “cash flow risk” part.

it has us identifying where cash flwo risk comes from. I sais in the Mortgage backed sector, ther eis lower prepayment risk in the rising rate environment because fewer people would be paying off mortgages in a risign rate envorninment, hence a positive effect. They are saying that it worsens their problem becasue peopel count on prepayment as part of their cash flows.

Is this an “either way is bad” type situation or am I forgetting some fundamental concept of mortgage backed’s?

In a MBS portfolio a prepayment assumption is built in to find out the expected average life of the investment (level II stuff). If rates rise, the holder of a MBS faces extension risk and therefore the possibility that cash flow do not occur as planned. This increase the cash flow risk.

So what is prepayment risk? If rates fall we expect prepayment risk to increase, is that not a cash flow risk too?

No . The risk is that the investment may not last for the duration , so we will have to get into a lower rate investment in the future. That may not meet the term structure of the liability and it could involve future cash flow at the same time.

yes, actually for MBS- some prepayment is anticipated & modeled.

If int rate goes down : there could be too much of prepayments happening (more than modeled) which shortens the duration & leave the firm having to invest now in lower int rate scenario…

If int rate goes up : there could only be few prepayments (less than modeled) which increases the duration

Both scenarios are cash flow risk