“if current implied interest rate volatility will exceed future realized interest rate volatility, then the appropriate strategy to hedge volatility risk is hedging dynamically. In this strategy, one lengthens durations by purchasing futures after interst rates have declined or shortens durations by selling futures after interst rates have risen” what is this about??? thx a lot
taken from one of the 2008 sample exams, sorry
If interest rates are expected to go up and you are planning to by a bond then it’s better to buy a short duration bond as you can roll them over at higher interest rates in the futures. In case you want to hedge with futures you would probably want to take the opposite position. Buy shorter duration futures when interest rates are expected to drop. Just taking a shot at explaining it 
agree that you can take the opposite side of your bond position with the futures, to “play” with duration, etc but what does this have to do with implied volatilty, future volatility, etc, in the context of hedging MBS securities??? I am freaking out. This f* question is not in schweser, or in an old exam with different material assigned… It is in the 2008 sample exams, and apparently the referred Study Session is 9-30-b “explain the risks associated with investing in mortgage securities and discuss wether these risks can be effectively hedged” wtf???
though i have read it and mugged up the relationship,I am not sure but I will give it a try… Since the CURRENT implied volatility is high the call option is expensive…we need to go long a call option to hedge the short call option in the bond…but it is expensive and since the FUTURE volatility is less the long option would fall in value and we would lose… so we hedge by long futures instead of long call optins. opposite is true when Implied volatility < actual volatility where we go long call options. I think the reasoning fits conceptually but I strongly advice to mug up the relationship ha ha ha
it is all abot vol, if you expect realized vol < implied vol, you should short options, else short futures
if rates fall then the duration of portfolio of MBS will fall… so long either call options or futures to increase the duration… and as mentioned above futures would be correct if impled> realized volatility
If God comes down to me and says “current implied interest rate volatility will exceed future realized interest rate volatility”, I’m not dynamically hedging anything. I’m shorting vol swaps and making some unlimited amount of money. It’s pretty odd that CFAI is suggesting that the choice between hedging with options and futures is about your expectations of vol. I think I want my hedging guys to be thinking about the proper risk to hedge and the right security to do it, not make vol bets under the guise of hedging.
Joey, you are totally right. I guess you know more about this than me: if implied volatility today is higher than future realized volatility, I just don´t care, the value of the option in the future will depend on future implied volatility, not future realized volatility, right? Applied to this example, this means that the value of the option can be higher, equal, or lower, depending on future implied volatility. So right now you can not tell if it is better to hedge with options or futures… Anyway: thanks for your answers, hope this kind of “conceptual” question don´t trick us in the exam… salu2
“implied vol today is higher than future realized vol” is almost certainly true for almost any option sold at any strike on any security anywhere in the world (which of course brings up the question of why don’t I short vol swaps all the time). There are billions of reasons for the previous but the big ones are that the underlying assumptions of the B-S world used to get implied vol are wrong and vol is in some sense smallest if they are right. “the value of the option in the future will depend on future implied volatility” sort-of but vol becomes less and less important as an option gets closer to expiration due to time decay. An option may well be worth lots of money because of realized vol, if that vol has taken the underlying in the right direction. What CFAI is saying is really nonsense, but the point is that using a hedge that makes a volatility bet only makes sense if you like the volatility bet. There are of course lots of other concerns in deciding between options and futures, but for hedging I would say it depends upon your utility. Just think about it from your own point of view - you are concerned about gasoline prices in the future because the F-350 you drive to work uses lots of gas. Do you want to agree to always pay $4/gallon or spend $100 to gurantee you will not pay more than $5 or just let it ride?
Thanks Joey, I really couldn’t figure out what was going on in this CFAI question. I just thought “if future vol < implied vol, shouldn’t you just be selling options.” I suppose that dynamic hedging is the way to make selling those options a little safer, but I would think that by hedging this way you are taking on a silly amount of risk, because: 1) dynamic hedging only works well for small changes in the underlying price, when the big danger is large changes in the underlying price. 2) transaction costs for the underlying are likely to eat away at your premia (this is an empirical question, but it seems highly likely). I suppose the bit about futures in the question is to reduce the transaction costs of dynamic hedging. I guess you’re arbitraging the information that future vol < implied vol and so the hedge locks in the difference in premia that you compute for each volatility. That’s why hedging makes some sense. But I must admit, on exam day, I’d be pretty confused by the wording.
hala_madrid Wrote: ------------------------------------------------------- > taken from one of the 2008 sample exams, sorry Is that in one of those $50 CFAI online sample exams ? I read about hedging the short call option in MBS in the CFAI text but nothing about Dynamic Hedging … Bad day to start the day …
yes, mo34, one of the sample exams
Dynamic hedging is covered in SS13 i believe with Options. Might be somewhere else also though…
hala_madrid Wrote: ------------------------------------------------------- > yes, mo34, one of the sample exams Maybe the other 3 choices were clearly wrong ? . Thanks for sharing … I’ll have to re-read this section from CFAI text. Looks like Schweser was lacking in many areas this year.
I think I’m still confused: “if current implied interest rate volatility will exceed future realized interest rate volatility, then the appropriate strategy to hedge volatility risk is hedging dynamically. In this strategy, one lengthens durations by purchasing futures after interst rates have declined or shortens durations by selling futures after interst rates have risen” I understand if Implied Vol > Future Realized vol, then its suggesting that the value of options today are overpriced and should be shorted. And I guess it’s best to hedge dynamically as the vol constantly changes through time. So I’m ok with that. Now Why would you lengthen duration after interst rates have declined? If interest rates then increase you will get hurt more than if you reduced your duration…and the opposite goes for the next part… Someone please clarify what I’m missing. thanks.
bigwilly Wrote: ------------------------------------------------------- > I think I’m still confused: > “if current implied interest rate volatility will > exceed future realized interest rate volatility, > then the appropriate strategy to hedge volatility > risk is hedging dynamically. In this strategy, one > lengthens durations by purchasing futures after > interst rates have declined or shortens durations > by selling futures after interst rates have risen” > > > I understand if Implied Vol > Future Realized vol, > then its suggesting that the value of options > today are overpriced and should be shorted. And I > guess it’s best to hedge dynamically as the vol > constantly changes through time. So I’m ok with > that. Now Why would you lengthen duration after > interst rates have declined? If interest rates > then increase you will get hurt more than if you > reduced your duration…and the opposite goes for > the next part… Someone please clarify what I’m > missing. thanks. Bigwilly, I believe the CFAI implies that when volatility is high, if interest rates decline in one period, there is a high probability they will decline even more in the next period, and vice versa. the reason I believe this is their reasoning, is their description of the re-balancing bands in the re-balancing SS. They say if an asset has high volatility use a narrow band for re-balancing as any deviation will be followed by an even larger deviation.
So your suggesting that CFAI is implying that serial correlation exists so a large decrease will follow another large decrease…I’m having a hard time chewing that one although in all due respect you may be correct…
bigwilly, 1. if interest rates go up, you lose if you are long futures, but you “lose less” in your mbs portfolio because the prepayment option is worth less = same direction in futures (loss for you) and prepayment option (profit for you) 2. if interest rates go up, you win if you are short futures, but you “lose less” in your mbs portfolio because the prepayment option is worth less = different direction in futures (profit for you) and prepayment option (profit for you) 3. if interest rates go down, you win if you are long futures, but you “win less” in your mbs portfolio because the prepayment option is worth more = different direction in futures (profit for you) and prepayment option (loss for you) 4. if interest rates go down, you lose if you are short futures, but you “win less” in your mbs portfolio because the prepayment option is worth more = same direction in futures (loss for you) and prepayment option (loss for you) Only 2 and 3 have some sort of offsetting effects, and 3 and 4 are the ones mentioned by CFA: “purchasing futures after interest rates have declined or shortens durations by selling futures after interst rates have risen” I am not sure, anyway, because the wording of cfa is: a. “AFTER interest rates have…”. If AFTER means a reversal and that is the reason to buy/sell futures, my reasoning no longer works b. My reasoning has nothing to do with volatility Also, bigwilly, check joey´s post: higher current implied volatility than future realized volatility does not mean that the option is overpriced. hope this helps
Looking quickly at your post I read the Question posted above as your bullet poitn “A” so everything you typed above doesnt hold as they are Increasing Duration when Interst rates are going to increase…