interest rate products

An Efficient
Approach to
Mortgage Pipeline
Risk Management

introduction
On the surface, the right of homeowners to prepay their mortgage
seems an innocuous little detail; at closing, it is little more than a
side note to the more important details of the loan (i.e., amount,
term, interest rate, etc.). For the mortgage lender, however, it is most
emphatically not innocuous. This prepayment right is, at its core,
what causes the prices of mortgages to behave differently from prices
of comparable Treasury securities, given a similar change in interest
rates. It also gives rise to the forces that make managing mortgage
pipeline risk so challenging.
More specifically, the prepayment right generates the various
phenomena that give a mortgage its “negative convexity.” As is well
known, when interest rates rise, Treasury securities lose value, as do
mortgages. Conversely, when interest rates fall, Treasury securities
gain value but mortgages experience price compression. That is, they
gain value to some extent but then level off due to the homeowner’s
prepayment option, the right to pay off the mortgage at par at any
time. This embedded cap on the upside performance of the mortgage
is an example of negative convexity at work.
An Efficient Approach to Mortgage Pipeline Risk Management
Despite the inherent difference in response to changes in interest
rates, it is possible to use exchange-traded risk management tools,
such as CME Group Interest Rate futures and options, to manage
mortgage pipeline risk. This can involve using combinations of
U.S. Treasury futures and options on those futures, Interest Rate
Swap futures and options on Treasury futures, or simply options on
Treasury futures alone. All of these alternatives offer effective and
cost-efficient mortgage pipeline hedges.
To demonstrate these mortgage pipeline hedge possibilities, this
paper will present a simplified analysis of pipeline risk to suggest
that pipeline and warehouse are parts of a unified whole, and that
fallout and prepayment risk are simply aspects of interest rate risk.
Next, it will outline an analysis of pipeline holdings emphasizing
the optionality of these assets. Using this foundation, the paper will
demonstrate the effectiveness of three hedging strategies:
• 10-Year Treasury Note put options
• A combination of 10-Year Treasury Note futures and options
• A combination of CBOT 10-Year Interest Rate Swap futures
and 10-Year T-Note options
Finally, after a brief discussion concerning option choice and hedge
construction, the paper will reiterate the several benefits that accrue
to users of these exchange-traded derivatives.
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cmegroup.com
A Simplified Analysis of Pipeline Risk
Mortgage hedging discussions often distinguish between pipeline
and warehouse risk and among fallout, prepayment and interest
rate risks. For the purposes of this discussion, the term “pipeline”
includes “warehouse.” “Pipeline” as used here extends from rate lock
to sale into the secondary market – typically a period of 60 to 90
days. Similarly, fallout and prepayment risks are considered special
cases of interest rate risk.
To understand the motive for these simplifications, consider
that before a mortgage closes, falling interest rates can result in
applicants withdrawing their loan applications, which is known as
fallout. Similarly, interest rates falling after the closing can result in
homeowners refinancing their mortgages. Both situations, fallout
and refinancing, are caused by the same factor – falling interest
rates – and in both cases, the result is the same: a mortgage drops
out of the pipeline. From this perspective, there is no reason to
distinguish between fallout and prepayment risk, nor between
pipeline and warehouse risk.
Conversely, if interest rates rise before or after closing, the
homeowner will be more likely to stay the course. In that case, the
number of mortgages in the pipeline will remain the same, but each
mortgage will be worth less than par. As a result, the lender cannot
realize full value from the sale of the paper.
Exhibit 1: The Effect of Fallout on Pipeline Value
Interest Rate Market Value of Number of Mortgages
Change (bps) One Mortgage
-100 $204,120
0 $202,831
+100 $192,397
2
Clearly, the challenges that accompany pipeline management are a
direct result of interest rate risk, and rising and falling interest rates
can each have negative implications for pipeline managers.
This is not to deny the importance of fallout risk or correctly
estimating prepayment speeds; the damage that fallout or
prepayment can do to a mortgage pipeline is significant. Although
fallout risk varies from region to region and even among banks
within a city, a simple example will illustrate the potential for
damage.
Assume a lender has issued 50 rate locks for $200,000 par mortgages
and, at the moment of issue, these mortgages have an aggregate value
of $10,141,528. Consider only two extreme situations.
Suppose this lender’s fallout experience is such that if interest rates
drop 100 basis points (bps), the fallout is likely to be 70 percent;
only 15 of these 50 mortgages will remain in the pipeline. In
contrast, if interest rates rise 100 bps, the fallout will be 10 percent
and 45 mortgages will remain. Exhibit 1 shows the initial value of
one mortgage (at zero interest rate change) and the values of one
mortgage at -100 bps and +100 bps. The “pipeline value” column
multiplies the -100 and +100 market values of one mortgage by the
number of mortgages remaining and the “full pipeline value” column
multiplies the -100 and +100 market values of one mortgage by the
initial 50 mortgages.
Pipeline Value Full Pipeline Value
15 $3,061,800 $10,206,000
50 $10,141,528 $10,141,528
45 $8,657,865 $9,619,850
 An Efficient Approach to Mortgage Pipeline Risk Management

Based on the initial $10,141,528 value, the 100 bp interest rate

drop caused a reduction in the size of the pipeline of slightly
more than $7 million. The 100 bp interest rate rise caused a loss
in the value of the pipeline of almost $1.5 million. Clearly, fallout
risk is not trivial.

A common observation among mortgage lenders is that for a

given number of rate lock commitments, some applicants will
close no matter what interest rates do. A larger group will most
likely close if interest rates remain stable. Yet another group is
extremely likely to fall out if interest rates drop. This observation
has guided earlier pipeline hedging recommendations, many
of which suggest a three-pronged approach to pipeline hedge
design: sell the first group forward, hedge the second group with
futures and hedge the third group with options.

The primary weakness of this approach lies in its inattention

to the characteristics that shape the prices of mortgages and
the failure to realize that the entire pipeline exhibits these
characteristics, not just the most problematic segment. As a
result, this type of hedge fails to address the real pipeline issues
and thus has failed to satisfy numerous pipeline managers who
have tried to hedge.

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cmegroup.com

A Different Approach to Pipeline Risk

When a lender makes a mortgage loan, the essential transaction Exhibit 2: Hedging a long treasury Position with
10-yEAR t-notE futures
is for the lender to buy the homeowner’s “bond.” Ordinarily, a
T 5 1/8 MAY 2016 TYM8 TOTAL
logical way to manage the risk that comes with owning a bond 1.0

is to sell futures. This works well for owners of U.S. Treasury

Gains (in millions of dollars)

securities, as Exhibit 2 illustrates. 0.5

This exhibit involves positions that are long a 10-Year Treasury 0.0

Note (the 5.125 percent maturing in May 2016) and short an

appropriate number of June 10-Year T-Note futures contracts -0.5

(TYM8). Rising interest rates drive the price of the Treasury Note
-1.0
lower and falling interest rates drive the price of the Treasury -100 -80 -60 -40 -20 0 20 40 60 80 100
Note higher. The short futures position exhibits the opposite Yield Shift (in bps)

response. The solid line (“Total” in the legend) represents the

net, or hedged, position. Note how closely this line follows the
zero line. The futures position neutralizes the effects of interest
rate change across a wide range of interest rates.
Given that a mortgage is also a bond, according to the common
wisdom, it seems logical to expect a similar futures hedge to
generate similar results. Unfortunately, a mortgage lender with
this expectation will be disappointed. Exhibit 3 displays the net
result of a position that is long a 5.5 percent coupon conventional
30-year mortgage (FNCL), which is hedged with a similar short
June 10-Year T-Note futures position. In this case, both rising and
falling interest rates lead to negative results. A common refrain is
that this type of hedge doesn’t work because of basis risk.

Note: In the exhibits in this paper, a negative for the number of

contracts indicates a short position and a positive in the number
of contracts indicates a long position.

4
 An Efficient Approach to Mortgage Pipeline Risk Management

To hedge mortgages with Treasury futures is to engage in a

Exhibit 3: Hedging a mortgage PIPELINE with 10-year
crosshedge and any crosshedge has exposure to basis risk. A t-notE futures
crosshedge involves hedging a position in one market (e.g., a 5 ½% Current Coupon TYM8 TOTAL
100000
corporate bond or a mortgage) with a position from a similar
but different market (e.g., Treasury futures). The basis risk arises

Gains (in millions of dollars)

0

because the corporate bond, for example, contains credit risk

-100000
which the Treasury security underlying the futures contract does
not. Because of this added element, the corporate bond price -200000

will respond to changes in the market assessment of the credit

situation and to changes in interest rates. The Treasury issue -300000

underlying the futures contract will respond only to changes in -400000

-100 -80 -60 -40 -20 0 20 40 60 80 100
interest rates. The difference in the responses is termed basis risk.
Yield Shift (in bps)

Even though basis risk is real, this seems an inadequate

explanation for the failure of the hedge illustrated in Exhibit 3.
Such an explanation overlooks the actual character of a mortgage
pipeline. Exhibit 4 displays the price-yield plot of the 5.5 percent
mortgage position alone.

Exhibit 3a

Pipeline Contents Price Yield Modified Duration Convexity DV01 Full Value
5.5 % Current Coupon 101-04 5.1947% 4.04 0.30 0.0410 $10,141,528
Hedge Position Price DV01 # Contracts
TYM8 119-19 0.0822 -50

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cmegroup.com

Again, rising interest rates drive the price of the mortgage lower. Exhibit 4: Price-Yield of a 5.5 percent mortgage
However, falling interest rates do not have the same effect as 5 ½% Current Coupon TYM8 115.5 TOTAL
100000
they do in the case of the Treasury security of Exhibit 2. Rather,
0
as interest rates fall, the price rises until roughly the minus

Gains (in millions of dollars)

-100000
25 bps area on the horizontal axis more or less levels off. This
leveling off, or price compression, is a manifestation of negative -200000

convexity, which results from the homeowners’ prepayment -300000

rights. -400000

-500000

In effect, the lender has bought bonds from homeowners and -600000
-100 -80 -60 -40 -20 0 20 40 60 80 100
sold the homeowners call options – the right to prepay or Yield Shift (in bps)
call away the mortgage. Any mortgage in a pipeline, then, is a
combination of positions that are long a bond and short a call
option. Further, this combination is equivalent, in risk-reward Exhibit 5: Short 10-yEAr t-note put position
terms, to a synthetic short put position. Exhibit 5 displays a TYM8 115.5
payout diagram for a position short 150 June 115.5 10-Year 200000

T-Note puts. Note the close resemblance between this plot and 100000
Gains (in millions of dollars)

0
the one in Exhibit 4.
-100000

-200000

-300000

-400000

-500000

-600000
-100 -80 -60 -40 -20 0 20 40 60 80 100
Yield Shift (in bps)

6
 An Efficient Approach to Mortgage Pipeline Risk Management

Let Actual Pipeline Characteristics

Shape the Hedge

Once the mortgage pipeline is seen as a portfolio of short puts, Exhibit 6: hedging mortgage pipeline with
it should become apparent that the way to immunize against the long 10-yEAr t-note put position

effects of changes in interest rates is not to go short Treasury 5 ½% Current Coupon TYM8P 116.5 TOTAL
800000
futures but to buy puts. Exhibit 6 illustrates how such a hedge
600000

Gains (in millions of dollars)

can work.
400000

200000

-200000

-400000

-600000
-100 -80 -60 -40 -20 0 20 40 60 80 100
Yield Shift (in bps)

Exhibit 6a

Pipeline Contents Price Yield Modified Duration Convexity DV01 Full Value
5.5 % Current Coupon 101-04 5.1947% 4.04 0.30 0.0410 $10,141,528
Hedge Position Price Delta DV01 # Contracts
TYM8P 116.5 0-44 -0.24 150

In this example, a $10 million par pipeline is hedged with a
position that is long 150 June 116.5 10-Year T-Note puts (TYM8P)
at a price of 0-44 (that is, 44/64ths or $687.50 per put). The put
position mirrors the mortgage position fairly closely. As a result,
the net position results in something close to neutral. To be sure,
when interest rates drop more than 40 bps, the net position
suffers a slight loss, but when interest rates rise, the net position
enjoys a gain.
A commonly raised objection to this type of hedge is its apparent
cost. A purchaser of options pays the premium in full when the
position is established; in this example, 150 puts at $687.50 per
put will cost $103,125. While this may appear to be a significant
cost for some institutions, after considering the benefits
illustrated in Exhibit 6, it should become clear that the benefits
outweigh the costs.

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cmegroup.com

An Equivalent Position for

Cost-Conscious Hedgers

An alternative to the long put hedge is a combination of short
futures and long calls. An intriguing fact about futures and
options on futures is that long or short futures can be combined
with long or short puts or calls to create synthetic option
positions. Thus, positions that are short futures and long a call
can replicate a long put position and this combination should be
able to neutralize the short put exposure of the mortgage pipeline
position.
116.5 10-Year T-Note puts. At a price of 44/64ths, or $687.50,
these 75 puts will cost $51,562.50. The total option position in
this version of the hedge will cost $91,875.30, which is still less
than the cost of the position that is simply long 150 puts.
Interestingly, for the most part the puts will be self adjusting. As
interest rates shift, the interaction of the put and call prices will
basically keep the hedge in balance. Exhibit 7 illustrates this.

Given the $10 million par pipeline exposure, the initial hedge Exhibit 7: hedging mortgage pipeline with
10-year t-note put-call combination
might consist of a position that is short 49 June 10-Year
CASH MKT ISSUES FUTURES/OPTIONS TOTAL
T-Note futures and long 60 June 123.0 10-Year T-Note calls 600000
(TYM8C). At a price of 43/64ths or $671.88, these 60 calls
400000
Gains (in millions of dollars)

will cost $40,312.80. In practice, this alternative can seem a bit

complicated. As interest rates rise or fall, hedgers must adjust the 200000

futures position to keep the hedge in balance. Fortunately, there 0

is an easier way that will produce satisfactory results.

-200000

-400000
Suppose the pipeline hedger determined that to protect this
example pipeline of 50 mortgages, he would need to buy 60 -600000
-100 -80 -60 -40 -20 0 20 40 60 80 100
June 123.0 10-Year T-Note calls and sell 49 June 10-Year T-Note Yield Shift (in bps)

futures. Because a short futures position will gain when interest

rates rise and prices fall, as will a long put position, he can reduce
the futures position and buy some puts – in this case 75 June

Exhibit 7a

Pipeline Contents Price Yield Modified Duration Convexity DV01 Full Value
5.5 % Current Coupon 101-04 5.1947% 4.04 0.30 0.0410 $10,141,528
Hedge Position Price Delta DV01 # Contracts
TYM8 119-19 0.0822 -30
TYM8C 123.0 0-43 0.24 60
TYM8P 116.5 0-44 -0.24 75

8
 An Efficient Approach to Mortgage Pipeline Risk Management

The total line in Exhibit 4, which Exhibit 8: The Unhedged-Hedged Contrast

represents the net of the pipeline and
Value Changes in the
the combined hedge position, stays close Value Changes
Pipeline Hedged with
Interest Rate Change (bps) in the Unhedged
to the zero line until interest rates drop T-Note Futures
Pipeline
and Options
more than 50 bps. Exhibit 8 reinforces the
graphic message by contrasting the results -100 $64,472 $48,317

of the unhedged and hedged pipeline -50 $66,406 -$852

at several points along the interest rate -25 $49,535 -$1,349

continuum. -10 $25,520 $808

Initial Rate Level 0 0
If the job of a hedge is to create a neutral 10 -$30,447 $72
position – no gains when interest rates 25 -$90,900 -$3,667
fall and no losses when interest rates 50 -$216,990 -$8,014
rise – this hedge is very effective. The 100 -$521,690 -$8,013
largest losses in the hedged column
amount to 0.08 percent of the $10,141,528
initial pipeline value, a trivial amount in
contrast with the 5.14 percent loss for the
unhedged position when interest rates rise
100 bps.

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cmegroup.com

Swap Futures Can Reduce Basis Risk

A further alternative involves substituting CBOT 10-Year Interest
Rate Swap futures for the Treasury Note futures in the hedge. A
combination of Interest Rate Swap futures and 10-Year T-Note
options generate a risk-reward profile similar to that of the T-Note
futures and T-Note options combination.
Exhibit 9 shows this version of the pipeline hedge using June
10-Year Interest Rate Swap futures (DIM8) to generate results
similar to the hedge using T-Note futures. Exhibit 10 contrasts
the results of the unhedged and hedged pipeline at several points
along the interest rate continuum.

Exhibit 9: Hedging mortgage pipeline with

An added benefit from the use of Interest Rate Swap futures 10-year interest rate swap futures
involves the issue of basis risk. The swap rate underlying this
CASH MKT ISSUES FUTURES/OPTIONS TOTAL
futures contract contains credit risk. Thus, as interest rates 600000

change, Swap futures prices will reflect both the interest rate 400000
Gains (in millions of dollars)

change and the market reassessment of the credit situation. A

200000
mortgage-Swap futures hedge is still a cross hedge, but it seems
reasonable to expect the use of CBOT Interest Rate Swap futures 0

to at least reduce the basis risk. -200000

-400000

-600000
-100 -80 -60 -40 -20 0 20 40 60 80 100
Yield Shift (in bps)

Exhibit 9a

Pipeline Contents Price Yield Modified Duration Convexity DV01 Full Value
5.5 % Current Coupon 101-06 5.1795% 4.04 0.30 0.0410 $10,147,778
Hedge Position Price Delta DV01 # Contracts
DIM8 115-27+ 0.0892 -25
TYM8C 123.0 0-43 0.24 60
TYM8P 116.5 0-44 -0.24 75

Exhibit 10: The Unhedged-Hedged Contrast with Swap Futures

Both the graphic and tabular accounts
show this to be a valid approach to Value Changes in the Pipeline
Interest Rate Change Value Changes in the
hedging a pipeline. The largest negative Hedged with T-Note Futures
(bps) Unhedged Pipeline
and Options
variation from neutral amounts to only
-100 $60,658 $65,791
0.10 percent of the $10,141,528 initial
-50 $64,028 $7,861
value of this pipeline. Clearly, it is possible
-25 $48,284 $2,839
to construct a robust pipeline hedge using
-10 $25,051 $2,512
combinations of CME Group Interest Rate
Initial Rate Level 0 0
futures and options.
10 -$29,909 -$1,483
25 -$89,756 -$7,793
50 -$215,160 -$16,748
100 -$519,130 -$10,411
10
 An Efficient Approach to Mortgage Pipeline Risk Management

The Choice of Options

Questions remain concerning how to choose Exhibit 11: Treasury Options Trading Terms
the options and how to construct the hedge.
Option Expiration First Trading Day Last Trading Day Number of
Days Traded
At a given moment, the options market offers
May 2008 1/28/08 4/25/08 88
a variety of choices of expirations and strike
prices. Options on Treasury futures have up
to seven expiration months listed: the first June 2008 7/20/07 5/23/08 308

three consecutive contract months (two serial

expirations and one quarterly), plus the next July 2008 3/24/08 6/20/08 88
four months in the quarterly cycle. Exhibit 11
includes the first three consecutive months
September 2008 1/8/08 8/22/08 227
and one of the next quarterly expirations,
September 2008.

The matter of expiration choice depends on the individual Options on 10-Year T-Note futures also present an array of strike
pipeline experience. Given the average time between rate lock prices. For example, the exchange offers June options on these
and sale in your pipeline, a reasonable choice is an option with futures with strike prices at half-point intervals. Exhibit 12
a slightly longer time to expiration. It is almost always wiser to displays a sample of the options available with June 10-Year
trade out of an option rather than deal with the mechanics of T-Note futures trading at 118-17 and 59 days to option expiration.
option expiration. For example, on February 15, the May 2008
expiration was 70 days away and the June 2008 expiration was 98
days away. Accordingly, if your normal pipeline term was 60 days,
the May expiration would be a good choice, but if your normal
pipeline term is as much as 90 days, the June expiration would be
the right one.

Exhibit 12: A Sample of Available Options on 10-Year T-Note Futures

Strike Price Put Price Implied Delta Call Price Implied Delta
Volatility Volatility
117.0 1-05 9.21% -0.35
117.5 1-18 9.26% -0.40
118.0 1-32 9.26% -0.44
118.5 1-47 9.23% -0.49 1-52 9.39% 0.51
119.0 2-00 9.24% -0.53 1-37 9.41% 0.47
119.5 1-24 9.47% 0.42
120.0 1-12 9.51% 0.38
120.5 1-01 9.52% 0.34
121.0 0-57 9.76% 0.31
121.5 0-52 10.13% 0.28
122.0 0-49 10.64% 0.26
122.5 0-46 11.11% 0.24
123.0 0-43 11.52% 0.22

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cmegroup.com

As a general rule, options with deltas in the 0.20 to 0.30 range

are the best choice, for two reasons. First, they cost less
initially. For example, in Exhibit 12 the June 118.5 call costs
1-52 (in option quotes, 1-52/64ths) while the June 123.0 call
cost 43/64ths. In dollars per option, the difference is between
$1,812.50 and $671.88.

As important as cost is, though, performance is probably more

important. With futures at 118-17, the 118.5 call is at-the-money
and the 123.0 call is out-of-the-money. For the purposes of a
mortgage hedge, the out-of-the-money call is also preferred
because it effectively responds to large declines in interest rates.
In contrast, the at-the-money call responds to all declines in
interest rates. Mortgage hedgers should be primarily concerned
with hedging the next 25 bps move rather than the next five bps
move. The out-of-the-money call also offers greater value to the
mortgage hedger because it is likely to produce a greater return
on investment (ROI) than the at-the-money call
if both options expire deep in-the-money.

12
 An Efficient Approach to Mortgage Pipeline Risk Management

A Note on Hedge Construction

Pipeline hedge construction can be accomplished effectively given the relevant quotes,
the ability to price the options, and a spreadsheet. To begin with, a good quote service
or broker should be able to provide mortgage and futures prices at various interest rate
levels for whatever mortgage coupons are relevant to any specific pipeline situation.

Based on these mortgage quotes, the hedger can easily determine the dollar amounts
his pipeline will gain or lose if rates rise or fall to the interest rate levels of concern. Any
reasonable option pricing program will allow the hedger to calculate option prices for
these interest rate levels and for the typical period of time in the specific pipeline.

Once these values are entered on a spreadsheet, it is a straightforward matter to

determine the number of puts or the combination of futures, calls and puts that will
constitute reasonable hedges. There is no magic formula for constructing these hedges,
but neither is this a hard puzzle to solve.

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cmegroup.com

The Bottom Line

Even with the market emphasis shifting increasingly to conventional prime mortgages,
pipeline risk remains a challenge. Fortunately, the set of risks confronting managers of
pipelines of these high-grade loans can be efficiently and cost-effectively managed with
CME Group Interest Rate futures and options. Specifically, U.S. Treasury futures, options
on U.S. Treasury futures and CBOT Interest Rate Swap futures can all serve well in
pipeline hedging programs.

Moreover, CME Group products offer significant efficiencies and benefits relative to
over-the-counter (OTC) derivatives, including counterparty risk mitigation, vast pools
of centralized liquidity, transparency of price discovery, clear and transparent market
valuations and significant operational and balance sheet efficiencies.

14
 An Efficient Approach to Mortgage Pipeline Risk Management

Headline

Subhead
Body

Futures trading is not suitable for all investors, and involves the risk of loss. Futures are a leveraged investment, and because only a percentage of a contract’s value is required to
trade, it is possible to lose more than the amount of money deposited for a futures position. Therefore, traders should only use funds that they can afford to lose without affecting their
lifestyles. And only a portion of those funds should be devoted to any one trade because they cannot expect to profit on every trade.

The information within this brochure has been compiled by CME Group for general purposes only. CME Group assumes no responsibility for any errors or omissions. Although every
attempt has been made to ensure the accuracy of the information within this brochure, CME Group assumes no responsibility for any errors or omissions. Additionally, all examples in
this brochure are hypothetical situations, used for explanation purposes only, and should not be considered investment advice or the results of actual market experience.

The Globe logo and CME Group® are trademarks of Chicago Mercantile Exchange Inc.

© 2008 CME Group Inc. All rights reserved.

15
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