about negative convexity

CFA Level III
#1

Negative convexity means the security loses more from a given increase in yield than it gains from a corresponding decrease in yield. In mortgage securities it is caused by the prepayment option. Mortgage securities can exhibit positive convexity, however, if the prepayment option is out-of-the-money (i.e., interest rates are higher than mortgage rates).

Due to negative convexity, a standard hedge against an increase in interest rates will likely result in a loss if rates decrease.

Is there anyone who knows what does “standard hedge against an increase in interest rates” mean? and why it will likely result in a loss if rates decrease.

thanks!

#2

1)standard = using treasuires or any other positive convexity security.

2)if you hedge the increase in rates, when rates decrease the loss on the hedge will offsett the price gain of the MBS

#3

2)if you hedge the increase in rates, when rates decrease the loss on the hedge will *MORE THAN* offsett the price gain of the MBS … This is why MBS’s are sometimes referred to as market directional.

#4

good lookin FinNinja, thats what i meant to write

#5

Thank you very much smiley

#6

I thought standard means the standard DURATION hedge by taking position in T Notes (futures)…is it not?