# A mortgage prepayment is essentially a call option? Currency Swap Question Bonus!

I’m trying to wrap my head around when to use short and long in mortgages and currency swaps. So here we go.

If a person takes out a mortgage, he/she essentially is selling a bond and the bank is buying it. In the mortgage agreement, there is a prepayment option, where a person can pay back the loan if interest rates go down.

Is it correct to say that I am short the mortgage and long the call option (prepayment option)?
Logic: (and here is were I get a bit confuse). As interest rates go down, the price of the mortgage/loan goes up (interest rates and price relationship), so I, as the individual, can call the loan or put it back to the bank. This makes me think I have a put option.

Now from a currency swap perspective, assuming the following:

LA Galaxy ltd will receive euros and pay interest in euros.
Chelsea ltd will receive USD and pay interest in USD.

If the LA galaxy receives euros, and has to pay interest in euros, wouldn’t they want the dollar to appreciate so to win on the exchange rate and therefore have to use less USD to convert to EUR to pay the interest? This makes me think they (LA Galaxy) is short the EUR and long USD?

The correct answer is, LA Galaxy is long the EUR and short the dollar. And the logic is because they have to pay interest in EUR, they are long the EUR.

I can’t seem to wrap my head around this. Help!

Yes.

Yes.

Yes: all of their future payments are in EUR, and all of their future receipts are in USD: they’re long USD and short EUR. If the value of USD (measured in EUR) increases, they win; if the value of USD (measured in EUR) decreases, they lose.

Who told you that that’s the correct answer?

Whoever they are, they’re wrong.

S2000magician,

The instructor in this video gives a similar example in which he values a fixed-to-fixed receiver currency swap and wants the answer in AUD.

In the video he says, the receiver will receive AUD fixed and pay USD fixed. This is equivalent to being long AUD fixed coupon bond and short USD fixed coupon bond.

If you refer to timeStamp: 29:30 to 31:10, you can see what I am talking about.

thank you

That’s absolutely correct: receiving AUD is tantamount to buying (i.e., being long) an AUD-denominated bond and paying USD is tantamount to selling (i.e., being short) a USD-denominated bond.

In your original post you said that the Galaxy will receive interest in USD and pay interest in EUR. So they’re long USD and short EUR, which agrees with what you say is in the video, and disagrees with what you said is the “correct” answer in your original post.

1 Like