The application of financial futures and options to home mortgages: An "optional" comparison of the ARM-FRM rate differential

Abstract

<p>The interest rate risk associated with owning a portfolio of fixed rate mortgages may be hedged away through offering adjustable rate mortgages. Financial institution, however, have other hedging choices available which may better match their intentions--reducing the risk of rising interest rates and falling values without eliminating the benefits of rising values in response to declining rates. Involvement in option market strategies may provide such an opportunity;This dissertation examines the comparative benefits of hedging a portfolio of FRMs with Treasury bond futures contracts and "covering" such portfolios with various option on T-bond futures contracts. The "best" hedging strategy will be identified as the purchase of financial futures put options;Further, since the basic pricing principles are the same for the two mortgage types, it appears that the difference between the two mortgages, from the financial institutions' point of view, is the extra cost of hedging the FRM. The efficient market hypothesis, then, suggests that the difference between the fixed and adjustable mortgage rates should not be more than the cost of hedging the FRM portfolio with a long position in put options on financial futures. This hypothesis is tested in the second part of this dissertation.</p>