Valuation Of The Prepayment Option In The Banking Book

One of the most important perspectives of interest rate risk in the banking book (IRRBB) is the valuation of socalled embedded options and the quantification of their impact on the value of bank portfolios. One unequivocal characteristic of mortgage portfolios is the option of prepayment, providing the borrower the possibility of redeeming their debt before maturity. We have created a theoretical model for valuing the prepayment option, based on which it can be demonstrated that, depending on the composition of the given bank portfolio (interest rate level, term to maturity), the prepayment option may have a significant effect on the sum of short-term interest income, as well as on the discount value of the bank portfolio via changing cash flows, and through this the value of economic capital. In this paper we analyse the impact of a possible model specification risk and the impact of changing the composition of banking portfolio under investigation.