Is it possible to get interest rate swaps on mortgages? If not, why not? Are there models that describe this? Any direction would be great.
closed as too broad by Joshua Ulrich, jeff m, olaker♦ Feb 8 '14 at 7:50
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Assuming the underlying mortgages that have been pooled into a Mortgage-Backed Security (MBS) are freely prepayable, the notional of the interest swap is unknown at inception. Therefore, you have two options - estimate a notional schedule to the best of your ability assuming some future evolution of interest rates (which are an important driver of prepayments) and tie your swap notional to this schedule (known as an amortizing swap), or even more rare, ask a dealer to quote you a "balance-guaranteed" swap that will exactly mimic the notional of the MBS. Obviously, since you are now asking the dealer to take on the prepayment risk, these swaps in most instances are so prohibitively expensive that they are rarely seen in the real world.
In practice, interest rate exposure on MBS is typically hedged by estimating the sensitivity (DV01) at different points on the curve using an embedded prepayment model that is sensitive to interest rates and offsetting the risk with the appropriate amount of bullet swaps at each point on the curve.