Option Contracts are the least used, most abused arrow in a risk manager’s quiver. For many successful risk managers in the mortgage banking industry they wouldn’t hedge a portfolio without them. Others wouldn’t touch them.

Two hurdles that must be overcome to use options effectively are (1) understanding the dynamics of the risk you are
hedging and (2) evaluating the option position(s) in the proper context.

The fact is options are a very malleable tools. This being the case, there is no single rule of thumb on when options are best and what arrangement is the best. The analysis by definition must be depend upon the situation.

Options help reshape your trade portfolio to have it mirror the value and volume sensitivities of your pipeline. Said
another way options hedge fallout volatility, interest rate spread fluctuations and price convexity differences. Options
hedge the unknown.

Anyone who has delivered loans into a “Best Efforts” commitment has used options. A Best Efforts commitment hold you harmless if you are unable to fulfill the commitment due to the loan not closing. In this way it differs from a mandatory commitment to deliver.

Typically you do not receive as high a price for the same delivery window for a Best Efforts commitment as you would for a Mandatory commitment. This price difference is the price of the option the investor has embedded in the product.

The question often turns to whether this price difference represents a fair value to you.

To answer that we first need to isolate the option component of the commitment.

Options that are fairly priced will typically cost you more for longer dated options than shorter dated options. Why? Longer forward time windows provide the opportunity for greater interest rate volatility. Interest rate volatility is the hazard against which we are seeking protection. Thus, like any actuary worth their salt, option market makers will charge more for options that cover more risk potential.

So, let’s take this back to our evaluation of a best efforts commitment. If the price spread between the mandatory
commitment and the best efforts commitment for between two forward window points, one of them is not fairly priced.Either the near window is over-priced or the deferred window is under-priced.

Next, let’s examine the profit and loss potential of the best efforts commitment. The best efforts commitment, at first blush looks like a put option. If rates go higher, prices go lower the holder of the best efforts will be immune from the decline in the market value for this commitment. However, unlike a put option the seller of a best efforts commitment will not benefit from a falling rate environment where prices appreciate (no matter how high they rally).

Thus, the best efforts alternative to a put option has a variable (opportunity) cost that must be considered. This forces one to use more of an econometric, as opposed to a transactional approach to come to grips with the marginal value of the best efforts trade versus an option trade.

One more consideration, that often tends to be the overwhelming catalyst for selecting a best efforts trade rather than a mandatory or option trade is the nature of the mortgage product being delivered. If the mortgage product being sold is a niche product with few or a single investor the best efforts may be far and away the best hedge value. However, when the product is widely traded and fungible across investor offerings, then best efforts lose their luster.

Greg Crosby manages the secondary marketing software and services product line having joined ASC in June 1997. Greg has been involved in the mortgage industry since 1981. His fields of experience include secondary marketing, financial and performance auditing, construction and design of financial conduits, software development, commodity and securities portfolio management, and design of risk assessment systems. He developed the Risk Manager and Servicing Shepherd™ software products. Greg has served as a chief financial officer, with both commercial banks and investment securities brokerage firms, and has served as an advisor and board member to companies ranging from service providers to financial conduits. Greg is considered an industry expert in the fields of secondary marketing and risk management has authored numerous articles, papers and a book titled The Theory and Practical Application of Improving Secondary Marketing Performance with Software Tools.