Joey, I took my question out of the otehr thread to see if you can help with this further: 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.
I guess that I need to know what exactly is being hedged but I guess the idea is that you are long MBS which means you are short a call. Thus you are using futures contracts to hedge the call. If you are hedging a short bond call with bond futures, when interest rates increase you need to sell some of the contracts because the delta of the option decreases.
ok, that helps a bit I guess since I/you dont know what the exact contact of the question was in its hard to put down a concrete answer.