2021/09/30 by Emanuele Casamassima, Lech A. Grzelak, Casamassima, Emanuele +5
Economics, Econometrics and Finance · Social Sciences · #Computational Finance (q-fin.CP) #FOS: Economics and business #Housing Market and Economics #Insurance, Mortality, Demography, Risk Management #Risk Management (q-fin.RM)
paper · pdf · doi:10.48550/arxiv.2109.14977
openalex publication_date 2021/09/30 · openalex created_date 2025/10/10 · openalex updated_date 2026/07/28
Understanding mortgage prepayment is crucial for any financial institution providing mortgages, and it is important for hedging the risk resulting from such unexpected cash flows. Here, in the setting of a Dutch mortgage provider, we propose to include non-linear financial instruments in the hedge portfolio when dealing with mortgages with the option to prepay part of the notional early. Based on the assumption that there is a correlation between prepayment and the interest rates in the market, a model is proposed which is based on a specific refinancing incentive. The linear and non-linear risks are addressed by a set of tradeable instruments in a static hedge strategy. We will show that a stochastic model for the notional of a mortgage unveils non-linear risk embedded in a prepayment option. Based on a calibration of the refinancing incentive on a data set of more than thirty million observations, a functional form of the prepayments is defined, which accurately reflects the borrowers' behaviour. We compare this functional form with a fully rational model, where the option to prepay is assumed to be exercised rationally.