To hedge a long position in a mortgage security, we short a 2 yr and 10 yr treasury…I’m sort of logically lost as to why we are shorting two treasuries? when rates go up, we are totally fine. when rates go down , -ve convexity kicks in and one short bond with +ve convesity is not sufficient and hence need for a second bond…so shouldn’t the second bond be a long position? why is it short…I know I’m missing something…any help please!!
i think it depends on the situation
Yes but you need to consider the TWIST in the YC…Example, Short terms rates decrease LT rates increase or the opposite. Or ST rates Decrease LT rates remain the same…or hte opposite of that. The 2 bond-hedge takes the TWIST in the YC into consideration whereas te Duration based 1 bond hedge only takes the level of interest rates (Parrallel shift). 2-bond takes Shift and Twist into consideration.
Yeah, I wrote the thing about how you need two bonds for convexity and duration, and the logic behind it still holds, but it turns out that the twisting aspects are more influential, as Willy said and I left that out (mostly because I underestimated the importance of twist).
as i stressed before convexity has nothing to do with 2 bond hedge., it is the cashflows that will increase if short ir will drop (curve will twist) (due to prepayments) that requires 2 bond hedge