can someone plz explain why we hedge based on rational exercise? ie if its a mortgage, and we assume rational exercise is 60% (meaning 60% will prepay when rates have fallen low enough for there to be a financial incentive to, and they will not prepay otherwise, while the other 40% do not behave rationally). then we only hedge for this 60%. then if rational exercise goes down, we hedge less. can someone first plz confirm if what i said above is true, and if so, why do we only hedge for the customers that behave rationally. thanks!
Sounds right to me (note however that just because some fund says that it would be “rational” to exercise mortgage options doesn’t make it so)