Delta hedging a two-fixed-income-
securities portfolio under gamma
and vega constraints: the example of
mortgage servicing rights
Carlos E. Ortiz, Chairman, Department of Computer Science and Mathematics, Arcadia University
Charles A. Stone, Associate Professor, Department of Economics, Brooklyn College, City
University of New York
Anne Zissu, Chair of Department of Business, CityTech, City University of New York, and Research
Fellow, Department of Financial Engineering, The Polytechnic Institute of New York University
Since July 2007, we have witnessed a growing number of mortgages
going into default and eventually being foreclosed. Mortgage servic-
ing rights are fees collected by institutions managing mortgages. The
yearly fees correspond to a percentage of the outstanding balance
of individual mortgages. Typically, an institution collects between 25
and 50 basis points per year (.25%-.5% of the outstanding balance
each year). The servicing is a compensation that institutions receive
for services that include the collection of the monthly payments, for
making sure that the monthly payments are paid on time, and, when
necessary, for foreclosing the property when a mortgagor defaults
on the property. Banks have been confronted with major losses
related to mortgage-backed securities and to the heavy reduction in
the volume of mortgage servicing rights.
Ortiz et al. (2008) develop a dynamical hedge ratio for portfolios of
mortgage servicing rights (MSR) and U.S. Treasury securities, such
that it is readjusted for changes in market rates and prepayment
rates. They develop a delta-hedge ratio rebalancing function for
three different portfolios, compare the three dynamic hedge ratios,
and rank them with respect to the gamma hedge ratio.
In this paper we develop a general model to obtain the optimal delta
hedge for a portfolio of two-fixed-income-securities (a1, a2), each
a function of the market interest rate y, such that when the value
of each of the individual securities changes up or down, because
of changes in market rates y, the total value of the portfolio is
unchanged. We develop the delta hedge under the constraint of a
zero-gamma in order to avoid costs related to the rebalancing of
such portfolio.
We first describe in details mortgage servicing rights (MSR), then
we develop the model, and finally discuss how our model can be
applied to MSR.
Mortgage servicing rights
Because MSRs correspond to a percentage of the mortgages’
outstanding balance their characteristics are the same as those of
interest only (IOs). IO securities have values that are both affected
by interest rates and prepayment rates. It is interesting to analyze
8 – The   journal of financial transformation
the price/yield relationship of an IO security in order to understand
MSRs.
Figure 1 shows the projected scheduled principal (at the very bot-
tom), the unscheduled principal, the interest, and servicing (top)
to be paid over time for a 5.5%-FNMA pass-through security. The
pass-through security is backed by a pool of mortgages with a cur-
rent balance of U.S.$52 million, a weighted average maturity of
28.8 years, and a weighted average coupon rate of 6.243%. The
cash flows are based on a projected PSA of 50, which corresponds
to an annual prepayment rate of 3% (cpr = 3%).
Because the graph in Figure 2 is compressed, it is important, when
comparing it to Figure 1, to read the numbers on the vertical axis.
Figure 2 shows what happens to the different projected cash flows
for a projected 1000 PSA (60% annual prepayment rate). Clearly,
the total principal being repaid overtime remains the same (same
area under the curve) under the two different prepayment scenari-
os, however, both the interest and servicing are being significantly
reduced for faster prepayment rate. When principal is refinanced,
no more interest is paid by mortgagors and banks cannot collect
servicing fees for mortgages that do not exist anymore.
Prepayment rates are a function of interest rates. When interest
rates decrease, prepayment rate increases and vice versa. Figure
3 graphs the projected cash flows of an IO security over time, for
different prepayment scenarios.
Figure 3 is taken from Bloomberg and shows the cash flows of a 9%
FHS IO under four different PSA scenarios. CPR stands for constant
prepayment rate. A CPR of 5% indicates that mortgage principal
is being prepaid at an annual rate of 5%. The prepayment model
developed by the Public Securities Association (PSA) is also widely
used for a basis of quoting prices on mortgage-backed securities.
A 100 PSA corresponds to a 6% cpr, a 200 PSA corresponds to a
12% cpr, and a 500 PSA corresponds to a 30% cpr. In the Figure,
PSA ranges from 0% to 395%. When PSA rate is high, more of the
outstanding balance is being prepaid, so less IO or MSR is available
as a percentage of outstanding remaining balance. This can be
 Figure 1
Figure 2
observed for example under PSA 395, the lowest curve in Figure 3.
On the other hand, for low PSA, the outstanding balance remains
at a greater level, and the derived cash flows stay higher (see top
curve for extreme scenario of 0 PSA).
It is important that the reader understands that the value of an IO,
or of a MSR, is the present value of the cash flows received over
time. Clearly, the lower the cash flows are (due to high prepayment
rates), the lower the value is. On the other hand, the higher the cash
flows are, due to high market interest rates and therefore low pre-
payment rates, the higher the value is. This is true only over a range
of interest rates (prepayment effect). At some point, however, the
discount effect takes over the prepayment effect, and the value of
IOs or MSRs will start to decrease. We show the typical value of an
IO or MSR as a function of interest rates in Figure 4.
The value of an IO security or a MSR increases when interest rates
(y) increase as long as the prepayment effect is greater than the
Figure 3
Figure 4
discount effect. When the discount effect takes over, we observe
the value decreasing for increases in interest rates. Both IOs and
MSRs are very interesting types of securities. Most fixed income
securities decrease in value when yields increase. IOs and MSRs do
the opposite for a wide range of yields.
S-curve prepayment function
It is important to understand the prepayment behavior in order to
value MSR. Periodically, investment banks submit to Bloomberg
their expected PSA level for corresponding changes in yield.
Figure 5 shows the data submitted by twelve investment banks
on their expected PSA levels for corresponding changes in yields
ranging from -300 bps to +300 bps, for the same 5.5% FNMA
pass-through security we described in the beginning of the paper
with Figures 1 and 2. It is interesting to observe how different
these projections can be. For a decrease of 300 bps, the projected
PSA ranges from 884 to 3125 (a corresponding cpr ranging from
53% to 187.6%).
9

Figure 5
Figure 6
Figure 6 plots for different changes in yield, the corresponding
expected PSA level for each investment bank that submitted
information to Bloomberg on October 2008 for a specific pool of
securitized mortgages. The changes in yield are represented on the
horizontal axis, with expected PSA levels on the vertical axis. The
curve represents the median for the twelve banks that submitted
the data. One can see that the prepayment curve, as a function of
changes in yield, has an S-shape. The S-shape prepayment function
is common to all banks, but each differs in projecting its magnitude/
steepness.
The S-curve shows a steeper slope around the initial market rate
(at 0% change in yield), with prepayment rate increasing as mar-
ket rates continue to drop, until a burnout effect is reached, and
the curve flattens, meaning that prepayment rate is no longer
increasing as it did in the middle range of market rates decrease.
The S-curve also flattens in the high range of market rates. What
10 – The   journal of financial transformation
happens is that prepayment rate decreases with increase in market
rates until it reaches a minimum beyond which no further decrease
in prepayment rates is observed. The natural level of prepayment
rate is reached, that is, the prepayment rate that is independent of
market rates, but is a function of mortgagers’ personal events.
We next, express the relationship between prepayment rate (we
use cpr for prepayment rate instead of PSA) and the change in
basis points. The prepayment rate, cpr, is mainly a function of the
difference between the new mortgage rate y in the market and the
contracted mortgage rate r. cpr = a ÷ [1 + eb(y-r)].
We now develop a general model for a two-fixed-income-security
portfolio that is delta and gamma hedged against interest rate
changes.
Model for portfolio optimization
We have a portfolio of two securities (a1, a2). Each security's value
is a function of the market interest rate y. We want to find the opti-
mal share of each security in the portfolio such that: Σi=k→2 αiai = K
(1), where αi is the weight of security ai. In order for the value K of
the portfolio, at a specific yield y, to be hedged against any move-
ments in interest rate we need to find the optimal weights for each
security in the portfolio, such that when there is a change in market
rates the sum of the change in value of each security times its cor-
responding weight in the portfolio is equal to zero.
We next, develop a general model and apply it to the particular case
of portfolios of mortgage servicing rights (MSRs). Consider two
functions ai(y), i = 1,2 and two coefficients αi, i = 1,2. We want the
following to hold: Σi=1→2 αiai(y) = K (2).
The values of the functions ai(y) are given for every value of y and
we want to find the values of αi that will satisfy equation (2), and
other conditions of ‘stability’ that we will describe later.
Notation: For any ƒ(y) let us denote by ƒ(n)(y) the n-th derivative
of ƒ.
When the αi’s are assumed to be constant, the objective is to find
for a fixed y0, hence for any given value of the ai(y0), values of the
constants αi, such that: Σi=1→2 αiai(y0) = K (3).
[Σi=1→2 αiai(y0)]1 = [Σi=1→2 αiai(1)(y0)] = 0 (4), where the second con-
dition represents the constraint that the total sum of the αiai(y0)
will not change for small changes in y from the initial value y0.
More generally, to obtain an optimal portfolio we need to find the
values of the αi for i = 1,2 such that for small changes in y from
the original y0, the value of Σi=1→2 αiai(y) will not change from the
original value of Σi=1→2 αiai(y0) = K.
For a fixed y0 there exists a unique solution that optimizes the port-
folio of two fixed income securities if: a1(y0)a2(1)(y0) – a1(1)(y0)a2(y0)
≠ 0. As expected, this condition depends only on the values of the
functions a1, a2 and their derivatives at point y0. The values for α1
and α2, the optimal weights for the two securities that constitute a
delta-gamma hedged portfolio, are:
α1 = [Ka2(1)(y0)] ÷ [a1(y0)a2(1)(y0) – a1(1)(y0)a2(y0)]
α2 = [-Ka1(1)(y0)] ÷ [a1(y0)a2(1)(y0) – a1(1)(y0)a2(y0)]
If: a1(y0)a2(1)(y0) – a1(1)(y0)a2(y0)] = 0
Then we have no solutions or there exist infinitely many solutions.
Examples of no solutions
It is not unusual to have a portfolio of fixed-income securities that
increases in value when market rates decline and decreases in
value when market rates rise. We could have, for example, a portfo-
lio composed of a 30-year 8% coupon bond with a 10-year Treasury
note. This is a case when it is impossible to delta hedge the portfolio
under gamma and vega constraints.
The case of mortgage servicing rights
A delta-hedged portfolio could have a combination of bonds and MSR.
We next present the valuation approach developed by Stone and
Zissu (2005) that incorporates the prepayment function (S-curve).
Valuation of MSR
The cash flow of a MSR portfolio at time t is equal to the servicing
rate s times the outstanding pool in the previous period: MSRt =
(s)m0(1 – cpr)t-1Bt-1 (5), where m0 is the number of mortgages in
the initial pool at time zero, B0 is the original balance of individual
mortgage at time zero, r is the mortgage coupon rate, cpr is the
prepayment rate, m0(1-cpr)t is the number of mortgages left in pool
at time (t), Bt is the outstanding balance of individual mortgage at
time (t), and s is the servicing rate.
V(MSR) = (s)m0 [Σ(1 – cpr)t-1Bt-1] ÷ [(1+y)t] (6), with t = 1,…..n (through
the entire paper)
Equation (6) values a MSR portfolio by adding each discounted cash
flow generated by the portfolio to the present, where n is the time
at which the mortgages mature, and y is the yield to maturity.
After replacing the prepayment function in equation (6) we obtain
the MSR function as:
V(MSR) = (s)m0 [Σ(1 – (a/(1+expb(y-r)))t-1Bt-1] ÷ [(1+y)t] (6a)
Valuation of a bond
The valuation of a bond with yearly coupon and face value received
at maturity is represented in equation (4): V(B) = c Σ1/(1+y)t + Face/
(1+y)t (7), where V(B) is the value of a bond, c is the coupon, Face
is the face value, n is the time at which the bond matures, and y is
the yield to maturity.
If we now relabel equation (6a) and equation (7) as a1 and a2 respec-
tively, and replace them in the equations we derived previously for
the optimal α1 and α2 respectively, we obtain a portfolio of bonds
and of MSR that is delta- and gamma-hedged against small changes
in interest rates and corresponding changes in prepayment rates.
Conclusion
With an estimated $10 trillion in outstanding mortgages, MSR gen-
erate a significant source of income for banks. This is a significant
market with risks that need to be addressed. If not managed prop-
erly, banks will have important losses to report. Prepayment risk
and interest rate risks need to be carefully evaluated when creating
a portfolio of fixed income securities. We have developed a gen-
eral portfolio of two-fixed-income securities, each with the optimal
weight, in order for the portfolio to be delta- and gamma-hedged
against small changes in interest rates. We have shown how this
model can be applied to portfolios’ MSR.
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