The Handbook of Financial Instruments

Chapter 30 Mortgage Swaps

David Yuen, CFA

Senior Vice President Portfolio Strategist/Risk Manager Franklin Templeton Investments

Frank J. Fabozzi, Ph.D., CFA

Adjunct Professor Finance School of Management Yale University

As explained in Chapter 14, the market for securities backed by real estate assets is a major part of the investment-grade bond market. An efficient strategy to gain exposure (both risk and reward) to the mortgage market is through a mortgage swap. A mortgage swap is a specialized form of interest rate swap developed in the United States. In this chapter we discuss mortgage swaps and other types of swaps (index amortizing swap and total return mortgage swap) that can be used by participants in the mortgage market.

FEATURES OF MORTGAGE SWAPS

As the name implies, a mortgage swap is a swap transaction entered between two counterparties based on the cash flows and performance of a pool of mortgages. It is a synthetic leveraged long position on mortgages. It is economically equivalent to borrowing funds at LIBOR (+/‒ a spread) and investing in a pool of mortgages or mortgage-backed securities.

As with other generic fixed-to-floating interest rate swaps, it has two legs: the fixed leg and the floating leg. The fixed leg is also referred to as the “mortgage leg” and the floating leg is also referred to as the “funding leg.” The mortgage leg replicates the cash flows of a pool of mortgages including the monthly coupon payments, monthly regular principal amortization, ...