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The option risk refers to the risk that investors of mortgage back securities are exposed to when loans are legitimately redeemed by borrowers, effectively cutting off their income stream.
It is common practice for lenders to sell the mortgages on the secondary market to financial investors after they originate the loans.
The exposure to risks is then passed on to these investors.
Defaults and bad loans are not the only risks that these investors are exposed to. But borrowers who pay off their loans also have an impact on their financial gains.
This risk of having the projected income stream cut short due to redemption is the option risk.