Prepayment risk on callable bonds: theory and test

We develop a framework for analyzing prepayment risk on defaultable callable bonds. We argue that prepayment risk emanates from the following informational asymmetry: Callable bond traders cannot determine the issuer's firm value-maximizing call policy, and their best anticipation is the optimal refinancing policy given by a term structure model. We show that, from the callable bond holder perspective, the issuer's departure from the optimal refinancing policy translates into an accrued exposure to market risk. The prepayment risk magnitude represents this risk transfer, and we show that callable bond traders can infer it from observable bond characteristics. Tests on callable bond transaction data provide strong evidence for prepayment risk and validate our conjecture that insurance companies trade callable bonds to reduce their exposure to prepayment risk magnitude.