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.