hedging mortgage prepayment option understand, different, comparing, listening, mortgage

ramzes

i was listening to a presentation the other day, and am a little confused. can someone plz explain how out of the money options and at the money options are used for hedging the mortgage prepayment option, as per below? i understand how the two prepayment models differ, but i don't understand how the model tells us to buy different kinds of options, what kind of options would usually be purchased, and why out of the money options are used? thanks!


so they were comparing two different prepayment models. in the first model, as soon as there is an interest rate incentive to prepay, forecasted prepayment rates jump up, and then remain at that same level even as incentive increases more. in the second model, as soon as there is an incentive, prepayment rates do increase but not by as much as in the first model. but as the incentive continues to increase more and more, the prepayment rate increases more and more as well.

the presenter mentioned that the first model is telling us we need to buy at the money options to hedge the prepayment option, whereas the second model is telling us we don't need to buy all at the money options, instead we can buy a combination of at the money options and out of the money options.

Andreas42

thanks guys!

sabre

Lets see if I can think my way through this. In both cases you are short optionality before you begin hedging.

The option you are short is the option to the homeowner, or their right to refinance. You hedge the duration drift and convexity by buying options.

In case one, you assume all borrowers have the same "strike" price, ie if rates go lower all borrowers will have equal incentive to prepay but different times they will do the prepay, maybe with some sort of distribution.

In this base case, since all borrowers have the same strike, and before rates go down none have prepay incentive, you could hedge with ATM options.

In case two, you assume some borrowers behave like case 1, but some are long OTM options, ie they need more of a move in rates to be ITM. You would hedge these borrowers using OTM options.

At least thats my logic by just thinking through it. Hope that makes sense?