Mortgage Options: Valuation, Risk Management, & Relative Value

September 29, 2008

Andrew Lesniewski
lesniewski@ellington.com

Ellington Management Group 53 Forest Avenue Old Greenwich, CT 06870

Mortgage Options p.

Acknowledgements
Zhouhua Li Jim Murphy Muhammad Sattar

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Mortgage options
Mortgage options = options on TBAs Expire 5 business days prior to the settlement of the TBA Standard strikes = {ATM, 1/2, 1} Quotes available from Deutsche Bank and Goldman Sachs

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Modeling mortgage options

Duration of the TBA assumed a function D (X) of the relative rate X = M C, where C is the coupon on the TBA, and M is the current coupon. Option value depends on the normal volatility of X. D (X) calibrated to the prepayment model implied duration. is implied by the options market.

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Duration of a TBA
We parameterize the duration of a TBA
10 8 6 4 2

-0.04

-0.02

0.02

0.04

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Duration of a TBA
by means of a logistic function of the relative rate X: D (X) = L + (U L) 1 1 + e(X)

The parameters L, U, and are determined by tting to durations computed from the prepayment model.

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Price of a TBA
This produces the following shape of the price function of the TBA:

-0.04

-0.02

0.02

0.04

0.9

0.8

0.7

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Price of a TBA
which is explicitly given by (L + U ) X P (X) = exp 2 cosh 2 cosh (X) 2
U L

This function is the key input to the option model. The value of = P (0) is determined so that the distribution of prices is consistent with the options market, and is close to par.

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Convexity of a TBA
The convexity of the TBA has the shape:
50

-0.04

-0.02 -50 -100 -150 -200

0.02

0.04

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Convexity of a TBA
and is explicitly given by the following expression: (U L) 1 (X) = D (X) 4 cosh2 (X) 2
2

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Calibrating duration function parameters

Generate macro rates scenarios (say, 25 bp, 50, 140, ...) and compute the corresponding durations of the TBA Fit the function D (X). For the Fannie 5.0, the calibrated parameters are: L = 0.677 U = 9.679 = 0.00344 = 108.624

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Calibrating duration function parameters

The graph below shows the durations of the TBAs of different coupons as a function of the current coupon.

10.00 9.00 8.00 7.00 6.00 5.00 4.00 3.00 2.00 1.00 0.00 0.00 FNMA5 FNMA5.5 FNMA6

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00

9.00

10.00

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Calibrating duration function parameters

On this graph, the TBA duration is compared to the calibrated logistic function D (X).

10.00

9.00

8.00

7.00

6.00 FNMA5 D(X)

5.00

4.00

3.00

2.00

1.00

0.00 0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%

8.00%

9.00%

10.00%

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Mortgage rate process

We assume that the relative rate follows a normal process dX (t) = dW (t) , X (0) = M C, where W (t) is a Brownian motion. The solution X (t) = M C + W (t) is implemented by a Monte Carlo simulation.

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Mortgage option price

Calls and puts struck at K and expiring at T are valued according C = Z (T ) E [max (P (X) K, 0)] P = Z (T ) E [max (K P (X) , 0)] Here, Z (T ) denotes the discount factor. The valuation formulas do not lead to closed form expressions, and the evaluation of the expectations requires Monte Carlo simulations. The simulations lead to fast and accurate results.

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Implied current coupon volatility

We can now easily calibrate the volatility by requiring that the price of the TBA, and the premium on the option match the market values. This is done in two steps: Choose the parameter = () so that the mean of the price distribution is the market price of the TBA. Choose to match the option premium. Currently (as of September 17), 265 bp.

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Implied current coupon volatility

Specically, here is the September 17 snapshot of the options market (November expires): FNCL5.0 99 016 FNCL5.5 100 26+ FNCL6.0 102 012 K K K 1 1 07 1 0 273 1 0 172 1/2 1 12+ 1/2 1 002 1/2 0 212 ATM 1 185 ATM 1 057 ATM 0 261 +1/2 1 095 +1/2 0 28+ +1/2 0 16+ +1 1 013 +1 0 201 +1 0 08+

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Implied current coupon volatility

and the implied current coupon volatilities (in basis points) are: K K K 1 262.5 1 263.7 1 259.5 1/2 263.4 1/2 265.6 1/2 261.6 ATM 264.2 ATM 267.6 ATM 263.5 +1/2 265.7 +1/2 270.1 +1/2 267.3 +1 267.4 +1 272.9 +1 272.1

FNCL5.0

FNCL5.5

FNCL6.0

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Volatility smile
Implied volatility exhibits smile:

275

270

265 FNCL5.0 FNCL5.5 FNCL6.0 260

255

250 -1 -0.5 0 0.5 1

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Relative value
The stochastic model allows to asses richness / cheapness of current coupon volatility: Versus realized current coupon volatility ( 235 bp as of September 17). Versus suitable swaption volatilities.

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Risk characteristics of mortgage options

Mortgage options are options on convex assets (prepayment options). Their risk is a composition of optionalities. Delta = BS T BA Gamma = BS (T BA )2 + BS T BA ...

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Delta risk of a mortgage call

2.50%

2.00%

1.50%

DV01

1.00%

0.50%

0.00% -500 -400 -300 -200 -100 0 Relative rate 100 200 300 400 500

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Gamma risk of a mortgage call

0.000300 0.000250 0.000200 0.000150 0.000100 0.000050 0.000000 -100 0 -0.000050 -0.000100 -0.000150 -0.000200 -0.000250 Relative rate

Gamma
-500

-400

-300

-200

100

200

300

400

500

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CC delta risk of a mortgage call

0.0020

0.0000 -500 -400 -300 -200 -100 -0.0020 0 100 200 300 400 500

CC DV01

-0.0040

-0.0060

-0.0080

-0.0100

-0.0120 Relative rate

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CC gamma risk of a mortgage call

0.00025

0.00020

CC Gamma

0.00015

0.00010

0.00005

-500

-400

-300

-200

0.00000 -100 0 Relative rate

100

200

300

400

500

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Swaption vol vega risk of a mortgage call

0.0000 -300 -200 -100 -0.0050 0 100 200 300 400 500

-0.0100

-0.0150

-0.0200

Vega

-0.0250

-0.0300

-0.0350

-0.0400

-0.0450 Relative rate

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Delta risk of a mortgage put

0.00% -500 -400 -300 -200 -100 -1.00% 0 100 200 300 400 500

-2.00%

-3.00%

DV01

-4.00%

-5.00%

-6.00%

-7.00%

-8.00% Relative rate

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Gamma risk of a mortgage put

0.000450 0.000400 0.000350 0.000300 0.000250 0.000200 0.000150 0.000100 0.000050 0.000000 -100 0 -0.000050 -0.000100 Relative rate

Gamma
-500

-400

-300

-200

100

200

300

400

500

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CC delta risk of a mortgage put

0.0040

0.0020

0.0000 -500 -400 -300 -200 -100 -0.0020 0 100 200 300 400 500

CC DV01

-0.0040

-0.0060

-0.0080

-0.0100

-0.0120 Relative rate

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CC gamma risk of a mortgage put

-500

-400

-300

-200

0.00000 -100 0 -0.00001

100

200

300

400

500

-0.00002

-0.00003

CC Gamma

-0.00004

-0.00005

-0.00006

-0.00007

-0.00008 Relative rate

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Swaption vol vega risk of a mortgage put

0.0800

0.0700

0.0600

0.0500

Vega

0.0400

0.0300

0.0200

0.0100

0.0000 -300 -200 -100 0 100 Relative rate 200 300 400 500

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