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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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