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Open Yale Courses ECON 251: Financial Theory Lecture 20 - Dynamic Hedging << previous session | next session >> Overview: Suppose you have a perfect model of contingent mortgage prepayments, like the one built in the previous lecture. You are willing to bet on your prepayment forecasts, but not on which way interest rates will move. Hedging lets you mitigate the extra risk, so that you only have to rely on being right about what you know. The trouble with hedging is that there are so many things that can happen over the 30-year life of a mortgage. Even if interest rates can do only two things each year, in 30 years there are over a billion interest rate scenarios. It would seem impossible to hedge against so many contingencies. The principle of dynamic hedging shows that it is enough to hedge yourself against the two things that can happen next year (which is far less onerous), provided that each following year you adjust the hedge to protect against what might occur
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This note was uploaded on 02/08/2012 for the course ECON 251 taught by Professor Geanakoplos,john during the Fall '09 term at Yale.

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