Risk at Work Advisory
Managing prepayment with replicating portfolios
Mortgages are an important asset on the balance sheet for all large Dutch financial institutions. Within mortgages there is embedded interest rate optionality, as mortgagors have the possibility to prepay part of their mortgage without penalty or break fees each year or prepay in full when moving to another house. Some of the behaviour surrounding exercise is dependent on interest rates and therefore the prepayment option can be seen as interest option at the side of the client. Hence, suitable management of the prepayment behaviour, requires this option to be priced and hedged as embedded interest rate optionality.
Historically, Dutch financial institutions have been applying static prepayment models, that specify a fixed (term structure of) prepayment rate(s) to be applied to the outstanding mortgage portfolio. Doing so underestimates the risks this option poses as it ignores the losses related to the non-linear behaviour of this optionality.
Using dynamic prepayment models brings computational challenges for real mortgage portfolios in current ALM systems. We show how replicating portfolios can be used for efficient revaluation and risk management purposes in this situation.
Bram is currently a partner at Risk at Work Consulting where he helps clients in the financial sector solving puzzles on quantitative risk management and ALM topics. Prior to joining Risk at Work, Bram held various trading and management roles both in the Netherlands and abroad. In the little time he has left next to family and work, he likes to read or pick up new hobbies such as playing the piano (at which he’s utterly awful). Bram has a M.Sc. in Industrial Engineering and Management Science with a specialization in operational research.