Banks issue mortgages with an embedded option for borrowers to prepay a part of the loan. However, this behaviour poses a risk to banks as it disrupts the level and timing of mortgage cash flows. From an earning perspective, when interest rates decrease, customers are financially incentivised to prepay their mortgages, resulting in a decrease in the bank’s income when the cash proceeds are reinvested at a lower rate. Conversely, from a value perspective, with an increase in interest rates, reducing the financial incentive to prepay, cash flows are moved further ahead in time, thereby increasing the duration of the mortgage. These two scenarios highlight the instability in the bank’s margin and value caused by prepayments. To address this risk, banks employ hedging strategies to mitigate the prepayment risk and achieve margin and value stability. This research aims to identify an effective hedging strategy that can accomplish both.
The research utilised the one-factor Hull-White model to simulate various interest rate scenarios, while an interest rate-dependent logistic prepayment model provided monthly prepayment rates based on the mortgagors’ refinancing incentives. Ten different hedging techniques were explored, including the internal funding, a static and dynamic notional hedge, and a static and dynamic value hedge. Additionally, a calibrated receiver swaption was included in each of these five hedging approaches. Subsequently, each of these hedging approaches was assessed for its margin stability, measured by the variance of the net interest margin, and its value stability, evaluated through the variance of the net present value, the average basis point value, and the NPV-at-Risk in ±200 basis point shocked interest rate scenarios.
The analysis indicated that relying solely on internal funding performs poorly in terms of both margin and value stability. Dynamic hedges were found to generally outperform their static counterparts, due to their ability to respond to market changes. Furthermore, the notional hedge demonstrates superior margin stability, while the value hedge exhibits the best value stability. Additionally, the analysis revealed that the incorporation of a receiver swaption significantly improves the NPV-at-Risk but has limited impact on the other risk metrics. Based on the conducted research, it is concluded that for a bank aiming for both value and margin stability, the most effective hedge strategy is the dynamic value hedge without the utilisation of a swaption. However, it should be noted that the ultimate choice for a hedging strategy depends heavily on the risk appetite of each bank. If a bank prioritises attaining margin stability, the recommended choice would be the dynamic notional hedge without the incorporation of the receiver swaption. On the other hand, for a bank that prefers value stability over margin stability, the dynamic value hedge without the inclusion of a swaption should be considered. Moreover, the final decision may also be influenced by mandatory requirements imposed by financial regulators, such as the European Central Bank.