can someone plz answer this: when the prepayment rate on mortgages increases, banks will hedge less. i dont understand why they hedge less. i thought if prepayment increases, this means there is more uncertainty (ie more sensitive to interest rate cahnges) and thus the bank would need to hedge more.
mbs hedging occurs when rates move in both directions. if prepayments increase, the duration of the mbs will decrease. in order to hedge, the mbs holder will extend duration by receiving on swaps
thanks. so when u say receiving on swaps, does this mean receiving fixed rates and paying floating rates. and if so, how does this extend the duration?
yes, i am referring to the fixed side. so receiving on swaps = receiving fixed. this extends duration bc receiving fixed on swaps is the equivalent to having a long position in bonds.
thanks a lot jax. can i bother u with some follow up questions? is the following correct then? so lets say its a 5 year mbs. and because of higher prepayment risk, the duration decreases to 4 years. then the bank will want to enter into a swaption that lets them enter into a swap (receive fixed, pay floating) after 4 years. and if theres lower prepayment risk and the duration increases to 6 years. then the bank will want to enter into a swaption that lets them enter into a swap (receive floating, pay fixed) to reduce the duration. just wanted to confirm if that was right? ive heard that when estimating prepayments, its better to be conservative since its better to be overhedged than underhedged. but then i dont understand how this makes sense if we hedge when prepayments go up and when they go down. thx.
*bump can anyone else respond to this?
jimjohn, I am no pro at hedging mortgage portfolios/pipelines, whatever. But, you seem to be mixing up duration (interest rate risk) with maturity/average live - as you said “because of higher prepayment risk, the duration decreases to 4 years. then the bank will want to enter into a swaption that lets them enter into a swap (receive fixed, pay floating) after 4 years.” Dont confuse 4yr duration with 4yr avg life. If rates decline and ur MBS shortens and you want to maintain a longer duration, you would enter into a swap, use swaptions buy tsys, buy agencies, buy futures, or whatever your method is to achieve ur target duration. If you are now short a year (ir your exaple of 5 yrs to 4yrs), you would want to add 1yr of duration to the portfolio. You have 10mm @ 4yr duration, lets say. You now have 400k of dollar duration (your theoretical p/l on 100 bp shift in rates). Your target is 5yrs, or 500k of dollar duration. You need to find 100k to make up the difference. You could add 10mm of something @ 1yr duration, or 1mm @ 10yr duration, or any derivation thereof. Swaps are a good choice because they don’t require a principal outlay like cash bonds. I am thinking outloud here, but if you wanted to keep cash flows going and your average life shortened, then you would enter into a swaption. You could then ensure that the last yr of payments occurs for you. I suppose you could also enter into a swaption that is slightly below the market in yield, so when rates decline, negative convexity kicks in, and you have a shorter portfolio, you have an option to receive in fixed some combination of the above math. But, it has nothing to do with getting those cash flows in 4yrs, it is about interest rate risk.
I’m not an expert either, my knowledge primarily focuses around my understanding of the GSEs. But they hedge the interest rate risk in their mortage portfolio actively. To simply things I sort of think about them having two core position in their derivatives book. One, they are a net fixed rate payer in swaps because they have significant positive duration on their balance sheet through their large mortgage portfolio. They move this duration book around as duration shifts as described well above, generally receiving more in swaps as rates fall and duration contracts and paying more in swaps as rates rise and duration extends. The other core position they have is a long vol position through swaptions. This is because they are short vol via the negative convexity in their mortgage portfolio, i.e. they have sold interest rate options to their mortgage borrowers via the prepayment option.
thx