  Understanding mortgage prepayment is crucial for any financial institution
providing mortgages, and it is important for hedging the risk resulting from
such unexpected cash flows. Here, in the setting of a Dutch mortgage provider,
we propose to include non-linear financial instruments in the hedge portfolio
when dealing with mortgages with the option to prepay part of the notional
early. Based on the assumption that there is a correlation between prepayment
and the interest rates in the market, a model is proposed which is based on a
specific refinancing incentive. The linear and non-linear risks are addressed
by a set of tradeable instruments in a static hedge strategy. We will show that
a stochastic model for the notional of a mortgage unveils non-linear risk
embedded in a prepayment option. Based on a calibration of the refinancing
incentive on a data set of more than thirty million observations, a functional
form of the prepayments is defined, which accurately reflects the borrowers'
behaviour. We compare this functional form with a fully rational model, where
the option to prepay is assumed to be exercised rationally.
