“To hedge duration exposure of a mortgage security you should sell t-bond futures when interest rates fall and buy t-bond futures when interest rates rise” Can someone explain to me how this works? Shouldn’t it be the opposite. A mortgage security exhibits negative convexity at low yields while a option-free bullet bond has positive convexity. If interest rates fall, bond prices go up but the mortgage security doesn’t go up as much because of prepayments. So to make the mortgage security behave more like an option-free bond, should you BUY t-bond futures instead of sell. T bonds will be going up in value at low yields, selling them will only exacerbate the mortgage securities negative convexity.
i think so too … that as interest rates fall, duration of MBS declines more than normal due to prepayment option. hence to hedge the duration exposure, we should buy t-bond futures contract as rates decline. and opposite for rates increase.
I agree with you both as well.
Here is how I understood this. “sell TBF when IRs fall” = “Sell TBF when IRs are low” basically what it says short them so when they rise again you are hedged. “buy t-bond futures when interest rates rise”=“buy TBF when IR are high so when they fall you are hedged” It doesn’t say “sell t-bond futures when interest rates ARE fallING and buy t-bond futures when interest rates ARE risING” V.
FinanceMBA2011: I think this is attempt to hedge the interest exposure part of MBS. portfolio manager is trying to be exposed to credit risk of MBS but hedge the interest exposure. The hedge is not perfect but jsut take the idea.