How to hedge an adjustable mortgage based on LIBOR index

Discussion in 'Trading' started by ivanbaj, Jul 17, 2009.

  1. I have an adjustable mortgage loan for $540,000 tight ot the 1 year LIBOR with fixed rate till 2013 September for 6.25% and margin of 2.25% and cap of 2%, Life time Cap of 5% and 1st change cap of 5%. The rate adjusts every 12 months after September of 2013.

    How do I hedge this against inflation? The current Eurodollar on CME is based on 3 month LIBOR and the 2013 September is at 4.45%. One contract has a value of $1,000,000

    How do I hedge for every year after that? I can't simply sell Eurodollar for every year after 2013. Should I pick what period of time I want to hedge and sell Eurodollar futures from that year? What about the fact that I need to hedge only $540,000 and one contract is $1,000,000? Is there a better instrument that I can use?
  2. The procedure is very simple, but will probably require a spreadsheet.

    1. Determine the sensitivity of your mortgage to a 1bp move in each of your forward fixings (you're going to have to make some assumptions)
    2. This will give you your bucketed DV01 exposure, but with yearly buckets.
    3. Simplistically redistribute your exposure into 3m buckets to fit the Eurodollar contracts, since you can't trade 12m LIBOR contracts (you're going to have to assume that the basis between 3m and 12m LIBOR is constant).
    4. Now you have calculated the sensitivity of your mtge to a 1bp move in every Eurodollar contract
    5. Offset this sensitivity by buying/selling the appropriate number of contracts. DV01 of a single Eurodollar contract is $25/bp (notional is irrelevant).
  3. Thanks! I will have to study your post for few days (if not weeks :)) but it seems that all I need is there.
  4. NP... It's not that difficult, if it weren't for all the little nasty technicalities.
  5. Simplify things in the following manner. Take your mortgage balance of $540,000 and divide by 25. That should be the number of eurodollar futures contracts you would need to scalp for 1 full-tick in order to paydown your mortgage balance. The larger your position size, the faster you can do it! :cool: