Hedging volatility with swaptions

Can someone explain, why & how we use swaptions to hedge the volatility risk in MBS?

I can try to help… well, let me go back to level 2 for a sec… volatility risk in MBS, I believe is referring to the volatility of interest rates, which impacts MBS b/c essentially the holder is short puts on interest rates, (as interest rates go down, people refinance ie prepayment), or you could view as short calls on the bond, either way you short some option. When you are short options, you are short “directional” volatility. If you would want to hedge against reinvestment risk you would need to enter into a hedge that protects against a decline in interest rates, but based upon the level at which the mortgages in the portfolio are paying interest at. if you are only interested in hedgeing repayment risk or have other means to hedge interest rate risk, you may want to enter into a swaption, that is the option to enter into a swap. If you begin to receive large repayments when interest rates are low, you are SOL. But if you had bought a swaption with the option to enter into a pay floating (based off 3M LIBOR) receive fixed, you could effectively “lock in” an interest rate. Now the amount of swaption notional you purchase is the next question? This could be done with some monte carlo simulations to determine prepayment risk based on different interest rate paths.

Whoa. What do you mean by “volatility risk in MBS”? Hedging prepayment risk is notoriously hard and using a short-dated (at least relative to the maturity of a pool of mortgages) option on the swap rate to hedge a path-dependent call on a different kind of bond is fraught with trouble. Of course, whenever I write something like that, someone who works in a bank comes back and tells me about industry-standard, Monte Carlo simulations, yada, yada.

MFE Wrote: ------------------------------------------------------- > I can try to help… > > well, let me go back to level 2 for a sec… > volatility risk in MBS, I believe is referring to > the volatility of interest rates, which impacts > MBS b/c essentially the holder is short puts on > interest rates, (as interest rates go down, people > refinance ie prepayment), or you could view as > short calls on the bond, either way you short some > option. > > When you are short options, you are short > “directional” volatility. If you would want to > hedge against reinvestment risk you would need to > enter into a hedge that protects against a decline > in interest rates, but based upon the level at > which the mortgages in the portfolio are paying > interest at. > > if you are only interested in hedgeing repayment > risk or have other means to hedge interest rate > risk, you may want to enter into a swaption, that > is the option to enter into a swap. If you begin > to receive large repayments when interest rates > are low, you are SOL. But if you had bought a > swaption with the option to enter into a pay > floating (based off 3M LIBOR) receive fixed, you > could effectively “lock in” an interest rate. MFE. Thanks. I was reading this paper (‘Hedging Mortgages, An OAS Approach’ by MS Research) which [said] that the first step in hedging the volatility exposure of mortgages is determinining the appropriate swaptions structures to use. So, if I strictly time the prepayment option exercise (due to the volatility), I would use an American Swaption. If I only wanted to hedge the interest rate risk, I can use swaps or bond futures.

They’re wrong or they are deluding you. The first step in hedging mortgages is to determine whether you have to use something like swaptions to do it and try not to. Hedging mortgages with swaptions is an excellent way to detonate.

Actually, they’re probably right if they’re talking $100B in mortgages…