Hedging Dynamically vs Options: The final showdown

Ok ladies and gentlemen, we need to settle this one and for all. I think i figured the basic point but i still have questions Hedging dynamically or with options refers to HEDGING CONVEXITY, that is why when interest rate decline, MBS duration falls and you want to increase duration (as to match positive convexity). Opposite happens when interest rate rise. Now the question is Why does OAS spread widens with increase expected volatility? If some one can explain this to me i would be grateful!

Well the Call option increases with Expected volatility. So the MBS price decreases b/c the required YIeld to assume that call option risk increases and thus the Yield Spread Increases. If hte Yield Spread increases, I would gamble to say the OAS would increase b/c of the increase in the call option.

but OAS is option adjusted spread… willy?

cfa just issued a new errata saying that this was optional just kidding… first of all, why do you say that oas spread widens with increase expected volatility? to be honest, I have no idea. but I just saw my level II notes, where OAS = zero volatility spread - option cost perhaps, keeping it very simple, if volatility goes up, option goes up, so oas goes down

hala, that is directly from CFAI books page 54 Volume 4 on the top

sh*t, is true

ok, no idea. although perhaps this make sense: expected volatility increases means the market expect volatility to go up, which will hurt your mbs because you are short the option, so there is more selling pressure on the mbs. this pushes down its price (and up its yield, which you can measure with the oas) any other ideas?

wrong, yield is measured with Z spread not OAS.

I’m just thinking logically. If Treasures are at 6% and the MBS is at 10%. Now if one expects volatility to increase, which will push down the price of the MBS, wouldnt you require a higher yield above the treasury to buy that MBS? I would so the OAS would increase…

comp_sci_kid Wrote: ------------------------------------------------------- > wrong, yield is measured with Z spread not OAS. well, it is measured by both, the difference is that oas is supposed to remove the effect of optionality. so if prices are going down and yields going up, both should go up (unless 100% of the movement comes from the option), right?

Yes…it’s 5:45am and I’m already up looking at this stuff thanks to a 5 month old that won’t sleep. Now for the question at hand… I tend to agree with Hala in the sense that optionality is supposed to be removed from the OAS spread. Unfortunately, the only answer that somewhat makes sense to me is the one that bigwilly wrote where if volatility increases, the value of the option on a MBS goes up, thereby decreasing the price on the MBS. Therefore, investors would demand higher yields and the OAS would widen. Problem is, I’m not sure this is the right explanation.

The MBS has a put option and so, when the interest rates rise, the value of the put option reduces (as the put is no longer as valuable). This widens the OAS. Does it make sense?

I don’t know that this is part of the curriculum, but it’s probably because of the uncertainty in prepayment prediction. If prepayments were perfectly predictable, the OAS of a credit risk-free MBS ought to be 0. Alas, the prepayments are unpredictable because people are not exercising options optimally. When interest rate vol goes up, unpredictability of prepayments goes up apart from the interest rate sensitive part.

CareerChange Wrote: ------------------------------------------------------- > The MBS has a put option and so, when the interest > rates rise, the value of the put option reduces > (as the put is no longer as valuable). This widens > the OAS. > > Does it make sense? I don’t think MBS has a put option and if it did OAS should acccount for that too.