“A common observation among mortgage lenders is that for a given number of rate lock commitments, some applicants will close no matter waht interest rates do. A larger group will most likely close if interest rates remain stable. Yet another group is extremely likely to fall out if interest rates drop. This observation has guided earlier pipeline hedging recommendations, many fo which suggest a three-pronged approach to pipeline hedge design: sell the first group forward, hedge the second group with futures and hedge the third group with options” can someone plz explain why we choose to use forwards for the first, futures for the second an doptions for the third in this case. or just in general, when is it best to use forwards or forwards vs options. thanks!
I think they have their order messed up. Group that signs no matter what: Just sell the mortgages before the applicant commits (that’s th “forward” part) Group that drops out if interest rates decline: A sure and certain loss that is hedged with futures contracts. Group that most likely closes if interest rates remain stable: Hedge with options as you only take loss if interest rates drop significantly.
thanks a lot joey. could you plz help me with these follow ups: “Banks guarantee mortgage rates for a period of sixty days or more. These commitments entail two kinds of risk: price risk and fallout risk. Price risk stems from the fact that market rates can change during the commitment period. Fallout risk occurs because the commitment is like a put option; the borrower has the right, but not the obligation, to sell a bond at a fixed price to the lender during the commitment period. A rise in interest rates above the locked rate during the commitment period drives the put in the money. A fall in rates has the opposite effect.” Isn’t this the other way around? If rates rise above the locked rate, that means the borrower would be getting a lower rate than the market if he closes with this commitment, and thus he would not want to exercise the option to sell back the bond. or is there something im missing here? “Group that signs no matter what: Just sell the mortgages before the applicant commits (that’s th “forward” part)” so does this mean that the bank sells the mortgages to investors right away, and that way they don’t have to wait until they have to sell to investors after the rates change closer to commitment date? “Group that drops out if interest rates decline: A sure and certain loss that is hedged with futures contracts.” just wondering how do i know that interest rates will decline to be certain that this will be a loss. and why would it be a better idea to use futures instead of options in this case. thanks so much!
*bump to joey just in case you didn’t get a chance to read this the first time. appreciate all your help
jimjohn Wrote: ------------------------------------------------------- > thanks a lot joey. could you plz help me with > these follow ups: > > “Banks guarantee mortgage rates for a period of > sixty days or more. These commitments entail two > kinds of risk: price risk and fallout risk. Price > risk stems from the fact that market rates can > change during the commitment period. Fallout risk > occurs because the commitment is like a put > option; the borrower has the right, but not the > obligation, to sell a bond at a fixed price to the > lender during the commitment period. A rise in > interest rates above the locked rate during the > commitment period drives the put in the money. A > fall in rates has the opposite effect.” > > Isn’t this the other way around? If rates rise > above the locked rate, that means the borrower > would be getting a lower rate than the market if > he closes with this commitment, and thus he would > not want to exercise the option to sell back the > bond. or is there something im missing here? The borrower is selling the bond. > > > “Group that signs no matter what: Just sell the > mortgages before the applicant commits (that’s th > “forward” part)” > > so does this mean that the bank sells the > mortgages to investors right away, and that way > they don’t have to wait until they have to sell to > investors after the rates change closer to > commitment date? > Yes > > “Group that drops out if interest rates decline: A > sure and certain loss that is hedged with futures > contracts.” > > just wondering how do i know that interest rates > will decline to be certain that this will be a > loss. and why would it be a better idea to use > futures instead of options in this case. > I should have said something like “a sure and certain loss if interest rates decline” > > thanks so much!