Hedging MBS: In Schweser notes there is a statements that I have problem with: 1." If the spread increases, increase the exposure to MBS" My reasoning here is that- MBS is a Fixed income security. It’s value will go down when yield increases- correct? Then why buy more ?
I’m not sure what the context of this is but I’m thinking this may help answer. When you are hedging with a MBS you have the ability to hedge away interest rate risk but active managers make their $$$ off of the changes in spreads. If you buy when spreads are wide, and then spreads narrow you make $$.
it is extension risk. With MBS, when interest rartes increase repayment risk drop dramatically, so you collect more interest. thats why it is good from a total return standpoint to buy more MBS when interest rates increase.
I thought it was just saying, if spreads increase = buy MBS, because when spreads revert to mean (fall in future) = MBS will rise in value.
When interest rates rise, while prepayment risk drops, extension risk increases. Perhaps one of the aforementioned explanations of yield pick up is the reason.
MBS Yield = Yield on Equivalent Treasury + OC+OAS So you are hedging IR risk using two bond hedge but you are not hedging Spread risk since want to captures OAS . If spread increase OAS will become more valuable .
Are you sure that is right CB? Can anyone else confirm? I agree that when you hedge MBS using a two bond hedge, you are doing so to gain exclusive exposure to the MBS spread, while attempting to remove IR risk. I.e. even if interest rates rise, you still can make money on the spread. But im not sure that the OAS will become more valuable if spreads increase? Though i have been wrong many many times before!!! 