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Hedging Forward Mortgage Loan Commitments: The Option of Futures and a Future for Options

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  • Kenneth J. Thygerson

Abstract

The purpose of this paper is to analyze theoretically the problem of how mortgage lending institutions assume the interest rate risks inherent in the granting of fixed‐rate mortgage loan commitments. Two approaches to hedge this risk are analyzed. First, the use of the GNMA futures market is evaluated from the standpoint of how it might be used to hedge against mortgage commitment risks. Secondly, the use of an appropriate pricing model—the Black‐Scholes option pricing model—is offered as a proxy for establishing the market value of a fixed‐rate mortgage commitment. This model is extended and empirically estimated for several hypothetical environments. The paper demonstrates a basic flaw in the GNMA futures market as a hedge against mortgage commitments. Once this is established, the use of the options pricing approach is offered as a more rational approach for hedging these risks.

Suggested Citation

  • Kenneth J. Thygerson, 1978. "Hedging Forward Mortgage Loan Commitments: The Option of Futures and a Future for Options," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 6(4), pages 357-369, December.
    • Handle: RePEc:bla:reesec:v:6:y:1978:i:4:p:357-369
    DOI: 10.1111/1540-6229.00186
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