I am confused about saying if this statement is true - for a multiple choice or vignette question. MBS generally follow the market, but when rates fall, they exhibit negative convexity. So should we say they are market directional or not?
if they’re properly hedged, then yes. Meaning, if you hedge interest rate risk (via 2yr and 10yr treas) that leaves you with spread risk. Someone verify me whether I’m completely BSing.
if well hedged , they are not market directional …market directional means high volatility
yes that’s right. i’m awesome.
I believe being w/ negative convexity does not contradict with being market directional
Market directional means payoff profile changes when the Market goes one way vs the other. Caused by prepayment risk in an MBS and associated negative convexity. If hedged it is no longer directional.
I would just say this: MBS are generally market directional, their value increases when rates go down, but not to the full extent like a non-callable bond To make them “truly” or “completely” market directional, you have to hedge them.
manishsd Wrote: ------------------------------------------------------- > I would just say this: > MBS are generally market directional, their value > increases when rates go down, but not to the full > extent like a non-callable bond > > To make them “truly” or “completely” market > directional, you have to hedge them. No, you have it backwards, they are considered market directional, UNLESS you hedge them.
that’s right…all bonds with negative convexity are market directional unless you hedge them
Okay - good to clear this about MBS. So - what about a regular non-callable bond - is that considered Market Directional also?
Think about it in relative terms compared to a vanilla bond benchmark…when interest rates fall, MBS’s suck compared to vanilla bonds (assuming you don’t do the hedge). MBS’s are only worth it (relatively) if interest rates increase.