Can you hedge your mortgage rate?
So you've gone for the floating mortgage rate. Seems cheaper at the time, right? In Australia, floating mortgage rates are around 6.6% and 7.6% for a fixed mortgage rate. Over in the US, the mortgage rates are more like 2.6% for a floating mortgage rate and 3.6% for a fixed mortgage rate. Firstly, yes us Australians appear to get a raw deal, and should move overseas. Everything about the cost of living in America has convinced me of that. But secondly, it doesn't take long (potentially just a few months) for your new floating mortgage rate to be equal to the fixed mortgage rate when you originally signed up.
There is no foolproof way of hedging your floating rate, and ensuring that your lower, starting rate is locked in for life. If there was, it wouldn't be offered to you. However, there are a couple of things that you can do in order to help to protect yourself from any future rate rises that are decided upon by those that already claim your taxes and jobs (for those public servants). They both involve trading products, and an element of risk, but can significantly cancel out rate rises if the maths is done correctly. Note that you would be trading futures over these products, meaning there are no coupons etc, just a capital gain or loss each day.
Mortgage Rate Hedging Strategies
1. Short sell government bonds with the same maturity as your mortgage. The price of fixed income securities, such as bonds, decreases as the interest rate associated with them rises, and the interest rate should track your floating mortgage rate, just always be a certain percentage lower. Your job is to calculate how much more your repayments will be if mortgage rates rise 0.25%. This is the amount that you want to 'profit' when the bond price falls as interest rates increase - the higher mortgage rate repayments should be offset by the profit made by shorting bonds, and if rates don't change, neither should the bond price. For those who are unsure, short selling means selling something first and buying it back later, hopefully at a lower price, therefore profiting from the fall in price.
2. Short sell bank bills around the time of the interest rate announcement (e.g. first Tuesday of every month in Australia). As with the bond example, you will profit if rates rise, and lose money (which will be offset by lower mortgage repayments) if rates fall. Rather than continuously holding a short government bond position, the price of which may fluctuate in between interest rate decisions (whereas your mortgage repayment won't), this method requires you to place a trade close to each interest rate decision, and exit the trade soon after. The other downside is that these are short-term securities (the futures may expire the month of the decision, unlike the bonds), so if there is no interest rate change, the price will change to that which reflects the ending rate (not any prediction of future rates). This may cause your profit and loss to change when your mortgage repayments do not, and so this must be factored into your calculations, and makes them more of an approximate hedge.
Neither method is a perfect hedge, but you should be able to offset the majority of interest rate fluctuations over the life of the mortgage, and most importantly keep the rate below that of the original fixed rate. In the US there are ETFs (such as PRIME ETFs) that track the government bond rate, but trading the bond itself is the easiest way of executing the trade. Always educate yourself in the trading products (feel free to ask questions here), and consider the risks before trading. Especially the wife's reaction when you explain that not only have you taken out a mortgage, but that you are using financial derivative products to help. Do not quote my name!