Within mortgages embedded interest rate optionality exists as mortgagors have the possibility to prepay part of their mortgage without penalty or break fees each year or prepay in full when moving to another house. This exercise behaviour is dependent on interest rates and therefore the prepayment option can be seen as interest option at the side of the client. Suitable management of the prepayment behaviour, requires frequent revaluation of mortgage portfolios which can be done with replicating portfolios.
BACKGROUND
Historically, Dutch financial institutions have been applying static prepayment models, that specify a fixed (term structure of) prepayment rate(s) to be applied to the outstanding mortgage portfolio. Doing so underestimates the risks this option poses as it ignores the losses related to the non-linear behaviour of this optionality. Due to regulatory requirements and advances in computation and modelling capabilities, there is an increasing pressure on financial institutions to use more sophisticated prepayment models. In this article we describe how the risk management of prepayment optionality can be aided by using replicating portfolios.
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- Prepayment modelling with Replication Portfolios .pdf • 0,66 MB