Anyone got a good handle on these 2 LOSes? the CFAI text description on those is very brief. What’s the difference between duration based approaches vs interest rate sensitivity approaches for hedging mortgage securities?
billwest i had the exact same problem! i couldn’t figure out where these OLSs start and end, i think both OLSs talk about the same thing. I’ll try to tell what i understood. But before that i strongly recommend that you click on this link (actually this is the first search result when you google two-bond hedge) and read from 237 to 251. http://books.google.com/books?id=eeIHRaKNky0C&pg=PA251&lpg=PA251&dq=“two+bond”+hedge&source=web&ots=Zbvo9zEuTM&sig=PTfUVuS2n7w68qxwU3F7JUp9dTk firstly duration based hedge doesn’t work when the yield curve twists (steepening&flattening), even for the parallel shift duration-based hedge is inferior. anyways the heart of the matter is the market directional feature of MBS that leads to asymmetric changes in price and thus a higher volatility of the error term. Actually when you look at the panel on pg68 when the yields increase 24bps the duration based hedge produces an error of $0.021 (profit) on $100 par. which sounds like a bargain, but when the yields go down the hedge produces -0.171. Now look at the lower panel (two-bond hedge case), the error is the same ,-0.076 on $100 par, when int rates go up or down. Also, I asked myself “well at least duration based hedge results in profit when the rates go up so why two-bond hedge is superior?” then i realized that the goal here is not to pick up some extra yield while being hedged but to reduce the volatility of “error”+remove market directionality and two-bond hedge does it perfect. Actually you still pick up extra yield when rates move in either direction bec of positive carry… Hope this helps PS:we are not supposed to do all these calculations to find the number of bonds to hedge in two-bond hedge case.