Hedging volatility risk of MBS

CFA Level III
#1

Sample exam 2 (paid 1) Given implied i volatility > expected future i volatility. I know that we should go for hedging dynamically. Question is: why do you purchase futures following a decline in interest rates? - sticky

#2

because you want to increase duration of your morgage portfolio (since duration decreased with decrease in interest rates)

#3

tanyusha Wrote: ------------------------------------------------------- > because you want to increase duration of your > morgage portfolio (since duration decreased with > decrease in interest rates) why do you want to increase your duration? interest rate has fallen and i would expect it will most likely rise … will lose $ on long futures … More hints appreciated. - sticky

#4

Sorry, don’t have a good explanation for you. My guess is that he needs to preserve his initial duration of portfolio (for whatever reason - maybe he has liabilities he needs to match). Selling futures/options would imply decreasing duration even more, no reason to do that either.

#5

Let me try…when hedgeing MBS, you need to break the golden rule of investing…you need to buy high and sell low (on future contract) to maintain the hedge for MBS.

#6

tanyusha explanation is exactly correct

#7

tanyusha Wrote: ------------------------------------------------------- > Sorry, don’t have a good explanation for you. My > guess is that he needs to preserve his initial > duration of portfolio (for whatever reason - maybe > he has liabilities he needs to match). Selling > futures/options would imply decreasing duration > even more, no reason to do that either. sorry, I am still not getting it. This is part of the hedging strategy, according to the solution. somebody explaining this with more details? csk? - sticky

#8

ws Wrote: ------------------------------------------------------- > Let me try…when hedgeing MBS, you need to break > the golden rule of investing…you need to buy > high and sell low (on future contract) to maintain > the hedge for MBS. sounds a bit vague to me … :slight_smile: - sticky

#9

Like tanyusha said, when rates are low, so is the duration of MBS, rates go down, casusing duration to become negative for MBS. You need to get more duration for your MBS (actually make it get back to positive to maintain the hedge), that is why you need to buy more future contract to increase your duration. When rates are low, future contract price are high, so you are buying high…when rates go up, hege for MBS need less duration, you need to sell off your future contract to reduce duration (when rates go up, future contract price go down, you sell low). That was what I meant by “buy high, sell low” Hope this helps some.

#10

sticky Wrote: ------------------------------------------------------- > Sample exam 2 (paid 1) > > Given implied i volatility > expected future i > volatility. I know that we should go for hedging > dynamically. Question is: why do you purchase > futures following a decline in interest rates? > > - sticky could it be… following a rate drop, the imbeded call option with MBS gets closer to the money. Implied vol shot up given the recent negative event. Hedge with futures will be cheaper than options.