What risk involves the early payoff of mortgages which can affect mortgage-backed securities?

Prepayment risk specifically refers to the possibility that mortgage borrowers will pay off their loans earlier than expected. This early payoff can occur for various reasons, such as refinancing due to lower interest rates, selling the property, or making extra payments. In the context of mortgage-backed securities (MBS), this risk is significant because the cash flows from these securities are dependent on the timely payment of principal and interest by borrowers.

When borrowers prepay their mortgages, investors in MBS receive their principal back sooner than anticipated. This can lead to reinvestment risk, as investors may have to reinvest the returned principal in a lower interest rate environment, potentially reducing their overall returns. Therefore, prepayment risk is a critical consideration for investors in mortgage-backed securities, as it directly impacts the expected yield and cash flow.

The other types of risks mentioned are related but do not specifically address the concern of early mortgage payoffs affecting mortgage-backed securities. Credit risk deals with the possibility of borrowers defaulting on their loans. Interest rate risk refers to the potential changes in interest rates that can affect the value of existing securities. Liquidity risk involves the potential inability to quickly buy or sell an asset without causing a significant impact on its price. Thus, prepayment risk is the most