2 Hedge Instruments!??

CFA Level III
#1

Can someone please explain this in plain English? Also, Do we need to know how to formulate/construct a two hedge instrument??? Thanks

#2

for MBS you have payments equaling interest and part of principal throughout the life of the mbs. That means that unlike a normal bond, there isn’t just one key interest rate and you are interested in being protected against movements of the whole curve. that is why you select 2 bonds, one short term and one long term to hegde your mbs.

#3
  1. Picture the MBS negative convexity curve. 2) Draw a line that bisects the curve. 3) now you know that the curve behaves differently in two halfs for interest rate change. 4) you thus buy two bonds - one for each half - to protect against an interest rate movement on any side. 5) You have now made a two bond hedge. Add salt according to taste. Yummy. Suggestion, remember how it works, its not that difficult. just study the numerical example from schweser
#4

i encountered on problem asking how could we hedge a MBS other than shorting the 2 and 10 yrs bonds. and the answer was with options or (depending on volatility), dynamic hedging. do you know anything about this?

#5

olfy Wrote: ------------------------------------------------------- > i encountered on problem asking how could we hedge > a MBS other than shorting the 2 and 10 yrs bonds. > > and the answer was with options or (depending on > volatility), dynamic hedging. > > do you know anything about this? yes, good question. i’m still confused by that section. from what i remember, options/dynamic hedge is used to control volatility risk, whereas the 2-bond hedge is used to control twists in yield curve. but why is hedging with futures preferred to hedging with options when you expect less volatility in the future?

#6

Just to confirm… to hedge the MBS, we SHORT both bonds, right? Or is it we long one and short the other (the short term or the long term?)

#7

phBOOM Wrote: ------------------------------------------------------- > Just to confirm… to hedge the MBS, we SHORT both > bonds, right? Or is it we long one and short the > other (the short term or the long term?) yup, it’s short two bonds of different maturities (or short futures of those bonds).

#8

lolly Wrote: ------------------------------------------------------- > but why is hedging with futures preferred to > hedging with options when you expect less > volatility in the future? I think you do this when your volatility expectation is lower than the implied (priced) volatility…option is overpriced.

#9

thanks jbaldyga. i’ve been stuck on this concept for a long time and now i don’t know why since your simple answer cleared it right up! thx.