# 2 Hedge Instruments!??

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

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.

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

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?

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?

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?)

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).

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.

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.