so here is my problem > for negative convexity bonds as interest rates fall duration also falls (the slope of price / yield = Duration, flattens)… so to counter this you increase the duration of your position by buying futures contracts (dynamic hedging, mentioned in Fixed income text, prepayment risk of MBS) now, MBS also exhibit negative convexity as interest rates fall>> so we SELL treasury futures to counter its interest rate risk (mentioned in FI text, interest rate risk of MBS) >> isn’t there a disconnect here?..for interest rate risk we sell futures, for prepayment risk we buy futures :?
anyone pls??
One is a process to start the hedge and the other is a rebalancing issue. To hedge the rates risk you sell futures. But that relationship will get out of balance because MBS duration is more sensitive to interest rates. If rates fall, MBS duration falls. Short T’s duration ~same. So you are short too much duration. You need to BUY duration so you buy back some of your shorts. If rates rise, the duration of the MBS rises and you are not short enough. You short more to compensate.
So I think to answer your question, in the case of buying, we are only buying a small % of the amount we are already short. Just small adjustments.
yes, that makes sense… thanks!