Can someone elaborate on why we want to short when int rates fall? 1,I understand when Int rates rise; the Mortgage securities act like regular bonds above their coupon rate. we would therefore short a forward (here two forwards, because see 2) 2,I understand why we would want to use two bonds. (because it’s not a one-for-one price movement when interest rates fall. But, when we think that Interest rates will fall, shouldn’t we LONG two futures as opposed to SHORT 2 futures? what’s missing on my part?
Wait…we are hedging your MBS holding, right? Why go short? Because you are long at your MBS holding.
ohhh… I am Long throughout the time period. i.e. I HOLD the asset. therefore protect the Long position by going short. Wow, what a short circuit. I was just focusing on what interest rates would do. not taking into account that I hold the underlying asset and how I would want to protect it. But let me ask you this? if I think Interest rates are going down, why would I keep my short positions in place? would it be that; the combination of the short 2 bonds and the long MBS would move together now (more or less) in conjuntion with the MBS. and, Therefore, our loss on the 2 short positions would be in check with the gain in the MBS. I.E. our best shot at our interpretation of the perfect hedge, assuming that we did it well enough? am I close?
Answer to your first question: Ok, if you know interest rates are going down, you won’t even consider hedging…you will go out find as many long-term bond as you could. Point being, since you won’t know for sure, that is why you are hedging. Answer to your second question: Yes. That is the idea of using two bond (long-term bond and short-term bond) to hedge MBS since MBS is more sensetative to the yield curve twist. yes, you are very close.
Thanks WS. That makes great sense, I here what you are saying about the interest rates going down. I would figure that you are better off getting whatever price appreciation you get on the MBS as opposed to taking the “full” hit on the short forward positions. So I guess then, my last point is, since we hold a MBS we would start off with Shorting 2 futures because it “immediately” prepares us for the unexpected.
y…e…s. I am trying to understand what you are asking at your last point.
Sorry, I just wanted to reiterate the dynamics of the MBS. it lends itself to a 2 bond hedge immediately i.e. you wouldn’t short a future and then short another future two weeks later to hedge a MBS because interest rates may have moved on you by then. you would want to get that 2 future hedge in place immediately to control for any possible losses. that’s all I was trying to state…I hope I am right in this logic?
Yes!!
good stuff!! thanks ws!!
No biggie.
while your at it , can you guys help me understand the following ?? "Since the mortgage securities are trading below par, they are likely to exhibit positive convexity " why ? I dont get it ?
mortgage security (or any other bond for that matter) is trading below par when interest is high (as compared to coupon on your instrument), with high interest (relatively speaking), it is unlikely that borrowers will prepay, and hence, MBS behaves like a regular bond, thus exhibiting positive convexity
^come on…if a MBS is trading below par…what does it mean? It means that interest rate has moved beyond(higher) its coupon rate…meaning that interest rate has gone up since its issuance. What happen when interest rate go up? MBS behave very much similar to bullet-bond…positive convexity.
>MBS is trading below par…what does it mean? It means that interest rate has moved beyond(higher) its coupon rate…meaning that interest rate has gone up since its issuance thx peeps …i should remember the above considering its lvl 1 stuff …