Hedging Mortgage-Backed Securities with Swaps and DV01

Summary

The document explains why hedging a mortgage-backed security with a swap is complicated when the underlying mortgages can be prepaid. Because prepayments depend in part on future interest rates, the security’s outstanding principal and the matching swap notional are uncertain at inception. One possible approach is an amortizing swap whose notional follows an estimated schedule. A balance-guaranteed swap could match the security’s changing balance, but would transfer prepayment risk to the dealer and is described as uncommon because it can be prohibitively expensive.

The answer says that practitioners typically estimate mortgage-backed security sensitivity at points along the yield curve using an interest-rate-sensitive prepayment model. They then offset the resulting DV01 exposures with bullet swaps at corresponding curve points. This is a concise description of a practical hedging framework, not a full modeling specification: it provides no calibration details, hedge results, or discussion of residual risks as prepayment behavior and rates change.

Key ideas

• Mortgage prepayments make an MBS’s future principal balance uncertain.
• An amortizing swap can use an estimated notional schedule to approximate the changing balance.
• A balance-guaranteed swap transfers prepayment risk to the dealer and is described as rarely used due to its cost.
• A common approach estimates curve-point DV01 with a rate-sensitive prepayment model and offsets exposures using bullet swaps.

Tags

# Is it more common to hedge a mortgage bond portfolio with other bonds as opposed to Interest Rate Swaps?


# Is it more common to hedge a mortgage bond portfolio with other bonds as opposed to Interest Rate Swaps?












Is it possible to get interest rate swaps on mortgages? If not, why not? Are there models that describe this? Any direction would be great.

## Answer by HookahBoy (score 2)

https://quant.stackexchange.com/a/10171

Assuming the underlying mortgages that have been pooled into a Mortgage-Backed Security (MBS) are freely prepayable, the notional of the interest swap is unknown at inception. Therefore, you have two options - estimate a notional schedule to the best of your ability assuming some future evolution of interest rates (which are an important driver of prepayments) and tie your swap notional to this schedule (known as an amortizing swap), or even more rare, ask a dealer to quote you a "balance-guaranteed" swap that will exactly mimic the notional of the MBS. Obviously, since you are now asking the dealer to take on the prepayment risk, these swaps in most instances are so prohibitively expensive that they are rarely seen in the real world.

In practice, interest rate exposure on MBS is typically hedged by estimating the sensitivity (DV01) at different points on the curve using an embedded prepayment model that is sensitive to interest rates and offsetting the risk with the appropriate amount of bullet swaps at each point on the curve.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.