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Principles of Financial Engineering, 3rd Edition by Elsevier Science

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Chapter 17

Caps/Floors and Swaptions with an Application to Mortgages

In this chapter, we use the mortgage sector as an example to study the financial engineering of swaptions. We explain how US mortgages’ prepayment clauses introduce convexities in banks’ fixed-income portfolios. We show that this convexity can be hedged using swaptions, which creates liquidity in the swaption market. Different approaches to the hedging of the swaption position including dynamic hedging are discussed. We discuss uncertainty regarding the prepayment date and the Bermudan nature of the swaption. The asset-liability management problem of mortgage agencies such as Freddie Mac and Fannie Mae is illustrated and the effect of prepayment highlighted. We present contractual ...

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