“Both X and Y are correct. Since mortgage securities exhibit negative convexity, two Treasury bond futures contracts are typically used as a hedge” DUH? I thought it is because they are amortizing securities and therefore sensitive to twists interest rate curve risk Schweser :-/
MBS’ are sensitive to twists because they exhibit negative convexity. the price of MBS reactes (as you know) differently at low and high ends of the yield curve.
strikershank Wrote: ------------------------------------------------------- > MBS’ are sensitive to twists because they exhibit > negative convexity. the price of MBS reactes (as > you know) differently at low and high ends of the > yield curve. yo do realize that 2 bond hedge doesnt hedge negative convexity at all?
explain further…i may not realize…
cuspy coupon MBS is a good example, it exhibts more negative convexity and 2-bond hedge won’t provide a desired hedge for it and it has to be supplemented with options. Esentially hedging prepayment option with another option, while 2-bond hedge provides a hedge for changes in level and twist of the yield curve
So a 2-bond hedge is insufficient only when the MBS is deep into the negative convexity soon and if so why?
volkovv Wrote: ------------------------------------------------------- > cuspy coupon MBS is a good example, it exhibts > more negative convexity and 2-bond hedge won’t > provide a desired hedge for it and it has to be > supplemented with options. Esentially hedging > prepayment option with another option, while > 2-bond hedge provides a hedge for changes in level > and twist of the yield curve Thanks volkovv, Another great example. Callable bullet. Guess what? You dont need 2 bond hedge to hedge this one. All you need is to correctly estimate duration (and yes, duration will be affected by negatiev convexity)
Point is, just because security has negative convexity it doesnt mean it should be hedged using 2 bonds hedge. Schweser dropped the ball AGAIN. AND AGAIN AND AGAIN AND AGAIN Pa-the-tic
I wanted to bump this question up, as it presents a good point for discussion. Opinions welcome