we are recommending an increase in the prepayment rate on mortgages for our hedging models. then someone says “if the prepayment rate has increased, then we will have to unwind the pay swaps” can someone plz explain what that means and why it has to be done when the prepayment rate increases? thx!
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“Unwind” = “get out of the trade in some way or other” “Pay swap” = “take the pay fixed side of an interest rate swap” = “short bond position” “prepayment rate increases” = you are long bonds, but someone else is exercising call options n you so you aren’t s long anymore.
Joey explained it well there. To put it in a different light, when the mortgages were originated, they were most likely hedged with a payer swap (you receive fixed coupon from the mortgage holder and swap it into a variable rate because your funding is most likely based on some sort of variable rate). Since the mortgages are getting prepaid you need to get out of the hedge swap.
thanks guys!