Question

FNMA has direct holdings of 30-year fixed-rate mortgages financed by three- to five-year agency securities sold to the public.

What kind of interest rate option could FNMA use to limit the interest rate risk? Explain how this would work. Explain how a collar could also be used.

Answer 1

The problem FNMA will face is that of asset liability maturity (or duration) mismatch. The mortgages have maturity of 30 years while liabilities have maturity between three to five years.

If the interest rate rises, the cost of funds will increase for FNMA however the interest income from the mortgages will remain the same. FNMA needs protection against this risk.

Interest rate Caps are the popular derivatives that generate income for the buyer or holder of the cap if interest rate rises. Thus FNMA, will receive payments at the end of each period when interest rate is higher than the strike price of the Cap. Caps, practically are, a series of call options on the index with floating rate. The payoff from the cap to the buyer will be:

Nominal Principal x (Index Level – Strike Price) x n / 360 where "n" is the number of days.

Hence, FNMA should buy interest rate caps for protection against rising interest rate risk.

Explain how a collar could also be used.

However, there is one problem with Caps. They are costly. FNMA may have to spend a significant amount as upfront as commission, or fees or premium to buy the Caps. IN such a situation, sources of funds can be Interest Rate Floors. So, FNMA can sell Floors to get the cash flows to buy the Caps. Such a situation where a borrower is long on Caps and short on Floor with the same underlying and same strike price, is called Collar. Thus, Collar position will:

• Help get the initial cash flows to buy the Caps
• Limit the interest rate risk