Reading 30 mentioned that to hedge the volatility risk of a mortgage securities, use options if the implied volatility is less than predicted, and use dynamic hedging if implied vol is higher than expected, can someone explain why?
I don’t know, I just remember this @_@ I also remember (well, not understand) that if you are dynamically hedging, you buy futures after interest rate has dropped, and vice versa. If sb could also explain this to me, that will be great
If interest rate drops, bond price would rise and so would duration, to hedge an increased duration, should we sell futures instead of buying?
Taking a stab… Options price is equal to the Intrinsic value (how much in the $) + Premium (which includes implied volatility (vega) and time (theta) and the other good stuff like bravo, charlie and froxtrot (jk on the bravo charlie and foxtrot part btw))… SO… if the implied volatility is low (and expected to go up in the future)… then the option’s prices is LOW(er than it should be in the future regardless of actual intrinsic value of the underlying)… Therefore, Implied Vol will INCREASE, and your options (whose price is part intrinsic, part Implied volatility) will also INCREASE. That’s why you go long options when you expect implied volatility to increase (cuz your option price should rise regardless of the underlying)… Think of it like this… if you see a stock go from 100 to 50 to a 100 to 50… etc… back and forth, then the volatility is friggin huge… (high current volatility)… so even if the stock was say 60 bux… a $90 call option, which is 30 out of moolah, would be worth like $1 or so cuz there’s a chance the stock could go back up to 100 (implied volatility high)… if the stock were to go from 50 to 51-52-53-52… etc… and never have ever come close to 90, then the 90 call would be worth N/A(0) to a penny… since there really isn’t any volatility implying that the stock may go above 90… Let’s say the mkt… priced teh option of the stock (one going from 100-50-100) @ a penny… then you should BUY/GO LONG the option right? cuz the volatility should increase in the future… If the mkt prices the option of teh stock that goes from (51-53) @ a dollar, you shouldn’t buy the option… cuz if you do you repeat level III… so you should go long futures cuz less premium involved… as for the hedge via futures part… i think it’s more Keep value of portfolio equal to liabilities… (cuz hedge means no change in value) So if rates went down… then your assets worth more than your liabilities… (cuz mbs/liability has neg. conv)… you now are more exposed to interest rate risk… if you go long futures, then when rates go back up… you’ll lose more quickly and bring u backt o net zero with liaib… & vice versa… makes no sense to me why we try to lose money quicker, but that’s how Ima remember it… cuz cfai said so…