Hedging a mortgage

Discussion in 'Trading' started by chromosome, Aug 3, 2009.

  1. Greetings:

    I am in the process of obtaining financing for a home purchase. The breakdown is as follows:

    Cash down payment (no rate): $15,000
    Cash down payment (floating 3% rate - follows PRIME, floats monthly): $47,500
    Loan from bank (30-year fixed, 5%): $187,500

    I am interested in setting up a hedging stragetgy to protect myself against the upward movement of PRIME. I am wondering if anyone has experience with this on a retail level.

    The specific question is whether or not there is an ETF product that follows the PRIME rate I may short or if a futures account would be a better idea. Any thoughts are appreciated, thanks!
  2. sjfan


    Even if you don't have access to PRIME, it's not a big deal; just use treasury futures since PRIME is basically Treasury + some spread that doesn't change all that often.

    The cheapest way to do it: You'll need to calculate the effective duration of your two loans, add them up, and then hedge using the number of futures contracts whose effective duration matches your loans.

    But any hedging is going to be imperfect: your loan exposes you to the full interest rate curve up to the 30 yr point. You don't have the ability to work with that; You'll be affected by curve shape change no matter what you do, but I'm sure you can live with that.

  3. If you want to use futures, be aware that you will also have to roll your position quarterly, however much this costs you (will depend on the specific arrangements).

    Otherwise, I agree with sjfan (except you seem to have only one tranche that's linked to PRIME).
  4. Can't you just switch to a fixed?

    Usually they'd use steepener trades to control what you want to control....
  5. sjfan


    Yeah... rolling is going to be a bitch;

    You could... I suppose... use an ETF on treasuries; the only problem is that you'll have to figure out the duration of the ETF (although you should know the general band depending on whether it's short, intermediate, or long - there's probably a bit of variations). I don't know if treasuries ETF publish their effective duration (not mac dur) often enough for this to be feasible.

  6. If futures contracts lose money, don't you have to pay the difference in margin? (I don't know if that's the case, but that's what I've read in all the books (I'm a newbie)). If that's the case, it could result in money out-of-pocket immediately which might not be a good thing.
  7. Is your mortgage tied to some benchmark (Fed Funds, 10 or 30 Yr T-Bond)?
    If so you need to hedge against it.
    You may consider selling options on it.
    It's NOT a perfect hedge (it gives you a limited protection range), but you get some extra money to help you with the mortgage, even if rates stand still.
  8. The risk in Prime against the 10-year rate per quarter is perhaps 50bp at one sigma. You're fixed loan is 4x the notional on the Prime loan. I would use TNX options at the cboe, if they're liquid, which I suspect they are not.

    There are June 2010 TNX/10-year rate options. A bull risk-reversal for say half of your notional would be a suggestion. Long an otm call, short an otm put; or the same-strike synthetic long. You can also trade the GE (eurodollars) or ZN futures options.
  9. The fixed rate piece is a conventional 30-year fixed rate mortgage. The piece I am worried about moving is the piece tied to prime. It floats and can (theoretically) move between 3% - 25% according to the terms of the loan.
  10. How common is mortgage hedging? How often is it done "correctly"? It could possibly be a good idea for a CTA to advertise that service if he had any idea what he was doing.

    Great thread btw.
    #10     Aug 10, 2009