Credit Risk Management Practice Exam

How is the constant prepayment rate (CPR) calculated?

1. 1 - (1 - SMM)^12

2. Total monthly payments divided by the total loan balance

3. (Total new loans - Total charged-off loans) / Total new loans

4. The sum of principal and interest payments divided by the loan maturity

The correct answer is: 1 - (1 - SMM)^12

The constant prepayment rate (CPR) is calculated using the formula 1 - (1 - SMM)^12, where SMM stands for the single monthly mortality rate. This method effectively translates the monthly prepayment behavior of a pool of loans into an annualized rate, reflecting the proportion of the remaining principal that is expected to be prepaid in a given year. The formula utilizes the single monthly mortality rate (SMM), which is derived from the actual prepayment activity observed over a month. By raising it to the power of 12 (to account for the twelve months of a year), we assess how the anticipated prepayments compound over the year. By taking the complement (1 - SMM) and calculating the result for a year, we derive the percentage of loans that are not expected to be prepaid, thereby allowing us to calculate the expected prepayment rate for that year. The other options do not reflect how CPR is determined. For instance, dividing total monthly payments by the total loan balance does not account for the timing or distribution of prepayments. Likewise, calculating the differences between new and charged-off loans does not consider prepayment behavior. Lastly, summing principal and interest payments does not yield the necessary information for CPR as it does