<h2>Prepayment Risk</h2>
<p>Prepayment risk, also known as early repayment risk, is a financial risk that arises when a borrower pays off a loan or other financial obligation before its scheduled maturity. This can have significant implications for the lender or investor, as it may lead to a loss of expected future cash flows.</p>

<h2>How It Works</h2>
<p>Prepayment risk typically occurs in scenarios where loans or investments have predictable future cash flows, such as mortgages, bonds, or structured products. When a borrower prepays, they may do so for various reasons, such as refinancing at a lower interest rate, selling the underlying asset, or improving their financial situation.</p>
<p>For lenders or investors, prepayment can lead to a loss of anticipated income. For instance, if an investor buys a bond with a fixed interest rate and the borrower prepays, the investor may not be able to reinvest the principal at the same interest rate, resulting in a loss of expected earnings.</p>

<h2>Why It Matters for Traders</h2>
<p>Prepayment risk is particularly relevant for traders who invest in mortgage-backed securities (MBS), collateralized debt obligations (CDOs), or other structured products. It can also impact traders who use leverage, as they may be required to repay their loans early due to margin calls.</p>
<p>Understanding and managing prepayment risk is crucial for traders to protect their portfolios and maintain consistent returns. It's essential to consider the potential for prepayment when analyzing the risk-return profile of an investment and to incorporate prepayment risk into trading strategies.</p>

<h2>Example</h2>
<p>Consider a trader who buys a 10-year mortgage-backed security with a 6% coupon rate, expecting to receive $60,000 in interest payments over the next decade. If interest rates fall, and homeowners refinance their mortgages at lower rates, the trader may face prepayment risk. If $40,000 of the principal is repaid early, the trader will only receive $20,000 in interest payments, resulting in a $40,000 loss of expected income.</p>

<h2>Key Takeaways</h2>
<ul>
  <li><strong>Prepayment risk</strong> arises when borrowers pay off loans or investments early.</li>
  <li>It can lead to a loss of expected future cash flows for lenders or investors.</li>
  <li>Traders should consider prepayment risk when analyzing investments and developing trading strategies.</li>
  <li>Prepayment risk can be managed through diversification, hedging, and careful portfolio construction.</li>
</ul>