PRICING AND HEDGING PREPAYMENT RISK IN A MORTGAGE PORTFOLIO

Emanuele Casamassima (), Lech A. Grzelak, Frank A. Mulder () and Cornelis W. Oosterlee ()
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Emanuele Casamassima: BlockTech B.V., Amsterdam, North Holland, The Netherlands
Lech A. Grzelak: Rabobank, Utrecht, Croeselaan 18 3521 CB, The Netherlands3Utrecht University, Utrecht, Budapest 6, 3584 CD Utrecht, The Netherlands
Frank A. Mulder: Rabobank, Utrecht, Croeselaan 18 3521 CB, The Netherlands
Cornelis W. Oosterlee: Utrecht University, Utrecht, Budapest 6, 3584 CD Utrecht, The Netherlands

International Journal of Theoretical and Applied Finance (IJTAF), 2022, vol. 25, issue 04n05, 1-37

Abstract: Understanding mortgage prepayment is crucial for any financial institution providing mortgages, and it is important for hedging the risk resulting from such unexpected cash flows. Here, in the setting of a Dutch mortgage provider, we propose to include nonlinear financial instruments in the hedge portfolio when dealing with mortgages with the option to prepay part of the notional early. Based on the assumption that there is a correlation between prepayment and the interest rates in the market, a model is proposed which is based on a specific refinancing incentive. The linear and nonlinear risks are addressed by a set of tradeable instruments in a static hedge strategy. We will show that a stochastic model for the notional of a mortgage unveils nonlinear risk embedded in a prepayment option. Based on a calibration of the refinancing incentive on a data set of more than thirty million observations, a functional form of the prepayments is defined, which accurately reflects the borrowers’ behavior. We compare this functional form with a fully rational model, where the option to prepay is assumed to be exercised rationally.

Keywords: Prepayment risk; conditional prepayment rate; CPR; hedging; mortgages (search for similar items in EconPapers)
Date: 2022
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DOI: 10.1142/S0219024922500169

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