Cuspy-coupon mortgage

Doesn’t the value of the prepayment option rise when rates fall?

Yes which decreases the overall MBS value. MBS = Treasury - Prepayment Option

The post below said as rates rise, the value of the prepayment option rises… I don’t think thats correct. PJStyles Wrote: ------------------------------------------------------- > you mean due to negative convexity don’t you? MBS > are market directional because the value of the > option rises and falls with interest rates > correct? As interest rates drop, the value of the > pre-payment option falls, adding value to the > MBS. > > Alternatively, as rates rise, the value of the > pre-payment option rises and MBS fall. The way to > address this, according to the CFAI text is to > separate the MBS valuation decision from the > portfolio’s duration decision. This can be done > using a proper hedging strategy ie: 2-bond hedge. > > > Do I got this down?

I think PJ might have meant that as Interest Rates Rise the prepayment Option does “rise” in the sense it becomes “less negative”, which increases the return on teh bond. If the prepayment option goes from -3 to -1 it has risen by 2.

What type of option would be best to hedge a cuspy MBS?

Well you have negative Call Option on the bond, so I would buy a Call Option on the bond. right.

Mmmmmh… right! Thanks big

I partially agree with bigwilly To hedge cuspy MBS you can use both calls and puts, or you may use a combination of them (all depends on particular issue, how deep you are in negative convexity territory, what are the option prices, maturities, etc). The natural way to hedge would be to buy a call or sell a put.

Or Buy a Call AND Sell a put to get the income from the Put.

that works too

Not in Schweser Notes.