What is the risk reduction’
Risk reduction risk faced by the holder of securities with fixed income. This risk happens when borrowers increase the rate at which they pay the maturity amount of the basic income.
Risk reduction is an integral part of the risk of prepayment, which generally increases as interest rates fall. It is the reverse reaction, because the decrease in rates can create an incentive for the borrower with a fixed rate loan to prepay all or part of the debt.
Breaking risk reduction’
Risk reduction occurs when borrowers pre-pay, thereby reducing the term of their attention. The calculation of the future profitability of debt securities such as mortgage-backed securities is based on interest rate and length remaining on the underlying loans. When borrowers repay a loan, shorten their Duration and reduce future interest payments.
Risk of early repayment the risk of early return of principal on the securities with fixed income. When principal is returned early, future interest payments not paid on the portion of the principal debt, that is, investors in the related securities fixed income will not get interest paid on the principal.
As The Reduction Of Risk Consequences Loans
Fixed rate loan risk reduction generally comes into play in lowering interest rates. When interest rates fall, borrowers may have to refinance at the new, lower rates. In variable-rate loans, the risk of contraction occurs when rates are rising and falling. This reaction is due to the borrowers desire to prepay their attention as possible before interest rates go up.
For example, imagine a financial institution that offers mortgage at a rate of 5 percent. What a financial institution expects to earn interest on investment over a 30-year mortgage period. However, if the interest rate is reduced to 3 percent, the borrower can refinance the loan or to accelerate the calculations. Prepayment reduces the number of years that they will pay interest to the investor. The borrower benefits from doing so, because they will end up paying less interest over the life of the loan. The owner of the mortgage, however, it ends a lower rate of return than originally expected.
Risk reduction, which usually happens when interest rates fall, is analogous to extension risk, which usually happens when interest rates rise. While the risk reduction occurs when borrowers repay a loan, shortening its duration, the risks increase when they do the opposite—they defer the payments on loans, increase of terms of crediting.