Pricing and Hedging Prepayment Risk in a Mortgage Portfolio

Emanuele Casamassima, Lech Grzelak, Frank A. Mulder and Cornelis Oosterlee

Papers from arXiv.org

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 non-linear 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 non-linear 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 non-linear 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' behaviour. We compare this functional form with a fully rational model, where the option to prepay is assumed to be exercised rationally.

Date: 2021-09, Revised 2021-10
New Economics Papers: this item is included in nep-cwa, nep-rmg and nep-ure
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