Replicating portfolios for mortgage prepayments

Mortgages are an important asset on the balance sheet for all large Dutch financial institutions. Within mortgages there is embedded interest rate optionality, as mortgagors have the possibilities to prepay part of their mortgage without penalty or break fees each year or prepay in full when moving to another house. Some of the behaviour surrounding exercise is dependent on interest rates and therefore the prepayment option can be seen as interest option at the side of the client. Hence, suitable management of the prepayment behaviour, requires this option to be priced and hedged as embedded interest rate optionality.