Updated for the 2026-2027 CFA® Level I curriculum.
Prepayment risk is uncertainty about when borrowers return principal before scheduled maturity. Faster prepayments create contraction and reinvestment risk. Slower prepayments create extension risk. Time tranching redistributes principal timing among classes but does not eliminate the mortgage pool's total timing risk.
Quick Answer
Prepayment risk is uncertainty about when borrowers return principal before scheduled maturity. Faster prepayments create contraction and reinvestment risk. Slower prepayments create extension risk. Time tranching redistributes principal timing among classes but does not eliminate the mortgage pool's total timing risk.
Key Takeaways
Mortgage borrowers may repay principal early.
Falling rates often increase refinancing and prepayments.
Faster prepayments shorten expected life and create contraction risk.
Slower prepayments lengthen expected life and create extension risk.
Time tranching assigns principal by stated priority.
Support tranches absorb more variability to protect other classes.
What You Need to Know for CFA Level I
Identify the underlying asset or structure.
Trace interest and principal cash flows.
State who receives payments and who absorbs losses.
Connect the structure to its main risks.
What Is Prepayment Risk?
Prepayment risk is the uncertainty created when borrowers return principal earlier or later than investors expect. In mortgage-backed securities, changes in prepayment speed affect the timing of cash flows, the expected life of the security, and the rate at which returned principal can be reinvested.
Contraction Risk vs Extension Risk
Prepayment risk can move in two directions. Faster-than-expected prepayments create contraction risk, while slower-than-expected prepayments create extension risk.
Risk | Prepayment Pattern | Typical Effect on Expected Life | Investor Effect |
|---|---|---|---|
Contraction risk | Faster than expected | Shortens | Principal returns earlier and may need to be reinvested at lower rates |
Extension risk | Slower than expected | Lengthens | Principal remains outstanding longer, potentially while market rates are higher |
Contraction risk is commonly associated with falling mortgage rates because borrowers have more incentive to refinance. Extension risk is commonly associated with rising rates because refinancing becomes less attractive.
What Is Time Tranching?
Time tranching divides principal payments among different classes according to a stated payment priority. The goal is to create tranches with different expected principal-repayment patterns from the same underlying mortgage pool.
In a sequential-pay structure, principal is directed to the first tranche until it is retired, then to the next tranche in the sequence.
A planned amortization class (PAC) is designed to receive principal according to a more stable schedule over a specified range of prepayment speeds.
Time tranching changes who bears the timing risk. It does not remove prepayment risk from the mortgage pool.
How Time Tranching Redistributes Risk
A PAC structure typically uses a support, or companion, tranche to absorb more of the variability in mortgage principal payments. This helps the PAC tranche maintain its planned repayment schedule while prepayments remain within the structure's protected range.
When prepayments are faster than expected, the support tranche can receive more of the excess principal. When prepayments are slower, principal can be redirected toward the PAC tranche while the support tranche receives less.
The support tranche therefore bears more contraction and extension risk. If prepayment speeds move far enough outside the protected range, the support tranche may no longer be able to absorb the variability, and the PAC tranche can also experience contraction or extension risk.
Interest Rate Scenarios and Prepayment Behavior
Mortgage rates influence borrowers' incentives to refinance, which can change prepayment speeds.
Falling mortgage rates often encourage refinancing, increasing prepayments and raising contraction risk.
Rising mortgage rates often reduce refinancing, slowing prepayments and increasing extension risk.
The relationship is directional rather than certain. Housing turnover, borrower characteristics, loan terms, and other factors can also affect prepayment behavior.
Illustrative Example
A mortgage pool supports a planned amortization class and a support class. When rates fall, prepayments rise and the support class initially absorbs extra principal to protect the planned schedule. When rates rise, principal arrives slowly and the support class receives less. If speeds move far enough, its capacity is exhausted and the planned class is affected.
Common Exam Traps
Reversing contraction and extension risk
Falling mortgage rates often speed prepayments, return principal sooner, and create contraction risk. Rising rates can slow prepayments, keep principal outstanding longer, and create extension risk.
Assuming faster prepayment always helps investors
Early principal may have to be reinvested at lower yields when rates fall, and the investor loses the higher-yielding cash flows that would otherwise continue.
Claiming time tranching eliminates prepayment risk
Sequential or planned payment structures redistribute the timing uncertainty across tranches. A more stable tranche is supported by another tranche that absorbs more variability.
Confusing a support tranche with a junior credit tranche
A support tranche absorbs excess or shortfall in principal payments to protect a planned amortization schedule. Credit subordination addresses losses from borrower defaults.
Treating scheduled principal and prepayments as identical
Scheduled amortization follows the loan contract; prepayments are unscheduled principal. Read the stem for refinancing, home sales, or extra payments before predicting cash flow timing.
Practice Question
When mortgage rates fall sharply, mortgage prepayments often increase. An MBS investor is then most directly exposed to:
contraction risk
extension risk
foreign exchange risk
Correct Answer: Option A
Faster prepayments return principal sooner than expected, exposing the investor to contraction and reinvestment risk.
Option B: Extension risk occurs when prepayments slow and principal remains outstanding longer than expected.
Option C: The scenario describes changing mortgage rates and prepayments, with no foreign-currency exposure.
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FAQs About Prepayment Risk and Time Tranching
What is prepayment risk?
It is uncertainty about the timing of unscheduled principal repayment.
What is the difference between contraction and extension risk?
Contraction is earlier return of principal; extension is later return than expected.
How does time tranching affect MBS?
It reallocates principal-timing risk among tranches according to a waterfall.