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Cuspy-coupon mortgage

I saw this term on CFA curriculum and have no clue wtf it means.
I know I could find this on the net.

But, if anybody knows what is a cuspy-coupon mortgage security, please give a brief explanation.

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“on the cusp” of where the security changes from having positive and negative convexity..

OK, I am an idiot.
I found the answer, just in the following line.

cupsy coupon mortgage security is a mortgage security for which changes in interest rates have large effects on prepayments, hence on price.

the other thing to know about them is that in addition to the two bond hedge, you need options to completely hedge for them. Like 3rd & Long pointed out they are on the cusp of change from postive to negative convexity, that’s the reason a regular two bond hedge won’t work.

cuspy = current cpn

CareerChange Wrote:
——————————————————-
> the other thing to know about them is that in
> addition to the two bond hedge, you need options
> to completely hedge for them. Like 3rd & Long
> pointed out they are on the cusp of change from
> postive to negative convexity, that’s the reason a
> regular two bond hedge won’t work.

regular 2 bond hedge wont work regardless if you take convexity into account

so 2 bond hedge is an imperfect, yet commonly used solution to hedge MBS. Is that an accurate statement?

Its the best solution so far…for CFAI concerns, right?

My newly acquired info on the cuspy-coupon;

In addition to a teo-bond hedge, you need an appropriate number of interest rate options to offset some or all of the negative convexity in these kind of securities.

so..after hedging your int rate risk with int rate options you are left with a 2 bond hedge that protects you from changes in the spread of MBS over the RF rate?

or am I totally off base?

As much as I can understand, the hedge has nothing to do with the spread. You do not hedge the spread any ways. If you do not want the spread risk, you don’t buy the MBS.

Once you buy the MBS you try to hedge interest rate risk (yield curve risk). But in case of cuspy (I like this new word:) two bond hedge is not enough to offset yield curve risk. You supplement it with options. As the embedded option in the cuspy is the element which screws your hedge.

someone from last year gave a good explanation in the link I posted above

“Two-bond hedge is a method of hedging against yield curve risk - both level and twist. Very easy formulae.

A cuspy-coupon is mortgage with coupon >> current rate…thus at serious risk of prepays, and in the ‘negative convexity zone’…thus highly sensitive to interest rate moves. For cuspy coupons, you generally want to buy some puts + calls to improve upon the two-bond hedge.”

Cool… glad I came across this post… Hadn’t seen the terminology cuspy coupon. So to summarize:

- Use a 2-bond hedge to protect/hedge against yield curve risk (non-parallel shifts) in MBS.
- If the coupon on the MBS is > current rate, it’s currently displaying negative convexity due to pre-payment option/risk and options should be used in conjunction with the 2 bond hedge to mitigate the risk.

Do I have the understanding correct?

As a quick quiz to all of you, and related to the same topic (MBS), what is meant by MBS are market directional or considered to be market directional. Explain your answer :)

Market Directional Investment: Belief that the investment is only attractive when when market moves in a certain direction - in this case, if interest rates rise (due to positive convexity).

you mean due to negative convexity don’t you? MBS are market directional because the value of the option rises and falls with interest rates correct? As interest rates drop, the value of the pre-payment option falls, adding value to the MBS.

Alternatively, as rates rise, the value of the pre-payment option rises and MBS fall. The way to address this, according to the CFAI text is to separate the MBS valuation decision from the portfolio’s duration decision. This can be done using a proper hedging strategy ie: 2-bond hedge.

Do I got this down?

Where is the specific reference to cuspy coupons in the LOS list ?

Is it something we will be tested on ?

CKBond Wrote:
——————————————————-
> Where is the specific reference to cuspy coupons
> in the LOS list ?
>
> Is it something we will be tested on ?

got the same Q…

be happy

I read CFA books before, and did not see this as well.

I came across while going through reading summary in CFAI curriculum.

Although it is not explicitly state in any of the LOs’s, I guess LOS regarding two bond hedge and anything related to hedge of negative convexity will include this as well.

It is in CFAI books, in chapter relating to 2 bond hedge of MBS, at the very end

Doesn’t the value of the prepayment option rise when rates fall?

Yes which decreases the overall MBS value.

MBS = Treasury - Prepayment Option

The post below said as rates rise, the value of the prepayment option rises…….. I don’t think thats correct.

PJStyles Wrote:
——————————————————-
> you mean due to negative convexity don’t you? MBS
> are market directional because the value of the
> option rises and falls with interest rates
> correct? As interest rates drop, the value of the
> pre-payment option falls, adding value to the
> MBS.
>
> Alternatively, as rates rise, the value of the
> pre-payment option rises and MBS fall. The way to
> address this, according to the CFAI text is to
> separate the MBS valuation decision from the
> portfolio’s duration decision. This can be done
> using a proper hedging strategy ie: 2-bond hedge.
>
>
> Do I got this down?

I think PJ might have meant that as Interest Rates Rise the prepayment Option does “rise” in the sense it becomes “less negative”, which increases the return on teh bond. If the prepayment option goes from -3 to -1 it has risen by 2.

What type of option would be best to hedge a cuspy MBS?

Well you have negative Call Option on the bond, so I would buy a Call Option on the bond. right.

Mmmmmh…. right! Thanks big

I partially agree with bigwilly

To hedge cuspy MBS you can use both calls and puts, or you may use a combination of them (all depends on particular issue, how deep you are in negative convexity territory, what are the option prices, maturities, etc).

The natural way to hedge would be to buy a call or sell a put.

Or Buy a Call AND Sell a put to get the income from the Put.

that works too

Not in Schweser Notes.