Managing Mortgage Prepayment Risk on the Balance Sheet

Dick Boswinkel

Mortgage loans form one of the largest asset classes on bank balance sheets. In most markets, they not only bear interest rate risk, but also introduce convexity and prepayment (model) risk to the balance sheet. In this chapter we focus on convexity and prepayment risk in the US mortgage market. Many of the results and ideas, however, can be applied to any mortgage market.

We first describe the different product forms that carry the prepayment risk that can be found on a balance sheet. Then we illustrate some empirical relations between prepayments and the market variables that are typically part of prepayment models. We briefly discuss how to compute value and sensitivities for mortgage products. We conclude by discussing how to incorporate these products into typical balance-sheet metrics.

BALANCE-SHEET PRODUCTS WITH PREPAYMENT RISK

In this section we discuss the different balance-sheet products that are affected by prepayment risk.

Mortgage loans

The most popular mortgage in the US market is the fixed-rate annuity mortgage. Common terms are 15 and 30 years and there are no prepayment penalties. This is the example that we shall follow. We assume a monthly compounding

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