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Expert Recommends Options as Pipeline Hedging Tool

A panel on managing pipeline fallout at the Mortgage Bankers Association of America's National Secondary Market Conference here suggested the use of options as a hedging tool.

There are two different strategies of hedging, said Peter J. Taglia, vice president of FTN Financial Corp. There are dynamic hedges and static hedges.

Those who use the dynamic strategy do not use options. Back in 1987, Mr. Taglia said he was a dynamic hedger. Then on Oct. 19 of that year, the stock market crashed. He got burned because he didn't use options. Both he and the other panel member, Bill Williams, first vice president of Commercial Federal Mortgage Corp., are now believers of using options.

Mr. Williams said options give hedgers positive convexity. A put option gives protection as rates fall and provides exposure if prices rise. A premium is paid for this option.

If the market rallies, the loss is capped by the premium, while the market tanks the option gains in value.

For the call option, if the market rallies, the hedger participates, but if it tanks the premium is lost.

Mr. Williams said advancements in front-end technology have led to better information, which in turn has contributed to a reduction in hedge costs.

The availability of real-time information has meant a reduced delay in the hedge decision, resulting in real-time hedging.

Another trend is branch level pricing, he said, which is leading to a transfer of fall-out risk to the production people. Risk-based pricing is leading to a quantification of fallout risk.

The panel gave their example of a $10 million pipeline and the hedging strategy they would use. There is $4 million of that pipeline that will close, so the hedging tool they would use would be forwards. Another $2 million would close, but it is not known when. For this segment they would use futures.

Options would be used for the $2 million segment that might close. For the last $2 million segment that won't close, they would not hedge that piece at all.

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