So this is from 2 different parts of the curriculum, but I was thinking that this strategy might work:
First, to provide a little color: reading 26 talks about hedging cuspy coupon bonds by taking a short position in 2 & 10 year tresuries + option positions. To make things simple let’s just look at the case if interest rates fall, in this case the hedging securities would be the 2 yr treasury and a long call option. This basically protects the investor from a loss in mkt value of the mortgage security. In the book this addition of the options is close to 7bps.
My question is: What if you were to, instead of buying options to protect the mkt value, you instead purchase a receiver swaption on the interest income that would be lost if rates decline. Would the receiver swaption cost less since it is on the interest and not mkt value loss (basically having a smaller notional)? Would the receiver swaption have effectively the same result, effectively removing the short call option from the mortgage security?
Even though you are getting your principle back on the mortgage security (causing you to have to reinvest at a lower interest rate), the income from the swaption would cause your effective interest income equivalent to the original mortgage security purchased.
I thought about this breifly last night and couldn’t find any holes, maybe the strategy is just outside the scope of the text? Anyone else see any issues with this?