Abstract
A fixed rate loan commitment that is binding on the lender but not on the loan applicant is equivalent to a put option. This article uses the Black-Scholes option pricing model to establish a value for fixed rate loan commitments and to derive the hedge ratio for the lending institution to hedge the interest rate risk associated with the commitments in the FHLMC forward market for mortgages. The effectiveness of the resulting hedge is tested in a simulation, where it is found that the result is a 71% reduction in the variance of the value of the lender's gain or loss associated with the commitment period.
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Maris, B.A., White, H.L. Valuing and hedging fixed rate mortgage commitments. J Real Estate Finan Econ 2, 223–232 (1989). https://doi.org/10.1007/BF00152350
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DOI: https://doi.org/10.1007/BF00152350