Using futures to hedge increasing ARM rates

Discussion in 'Economics' started by Vol, Sep 18, 2007.

  1. Vol


    I've searched but I can't find where this has been discussed before. ARM rates are often tied to the LIBOR rate. There is a CME future for one-month LIBOR rates.

    Could someone with an ARM mortgage use this product to protect an increase in their mortgage payments? One could either short the future or buy puts to take advantage of rising rates. The initial/maintenance margins are 650/500 per contract. Seems like this would have been a low risk investment starting in mid 2003 to early 2004.

    Many are and will be defaulting on their mortgages and losing their homes. All because of rising mortgage payments. It looks to me like they could have largely hedged this problem with EM futures. If I was a loan officer and I knew this I would tell everyone who was getting an ARM about it. Would this simple investment have avoided the sub-prime fiasco? This is too simple - I must be missing something. If so, I sure would certainly appreciate it if somebody would point it out to me.
  2. This is a good idea but the wrong instrument unless your mortgage is 3 million dollars.

    Depending on your mortgage size and terms you might be able do something with treasury futures but it would be complicated. You will have to do some math, take some basis risk, and accept a crude hedge ($100k increments, no fine rebalancing). I am envisioning an NPV hedge, I think a cash flow hedge might be impossible with futures.

    I wanted to do something similar when we were shopping for a house last spring but my wife was too scared. My situation was simpler, I basically wanted to lock in the current rate for a few months. I wish we had, our rate went up almost 1% from the first time we got prequalified until we closed.
  3. Vol


    The $3M does not refer to an amortized loan. The math is tricky and it depends of how much of a hedge you want. 1 pt move in the future = $2.5k. 1 pt seems to equal 1% in the LIBOR. i.e. if LIBOR rate goes up 1% EM goes down 1 pt. You could figure how much extra interest you would pay for the life of the loan per % rise in the rate. Then divide this by 2.5k and you will have the number of contracts to buy. That is to be fully hedged. Make any sense?