PSA Duration: Conquering the Prepayment Risk of Mortgage Portfolios

Abstract

Money managers have little control over the values of their individual holdings, but they have considerable control over the risk exposure of their portfolios. This paper introduces new tools for the risk management of mortgage portfolios. We extend the traditional duration analysis to two dimensions - interest rates and mortgage prepayments - and develop independent hedging rules for the interest rate risk and the prepayment risk. In particular, we define the PSA duration as a formal measure of the mortgage prepayment risk and as a mortgage market counterpart of the traditional bond duration, commonly used in fixed-income practice for managing the interest rate exposure. The exposition is accompanied by a number of market applications to risk hedging and fixed-income portfolio design.