(solution to Q3, page A-5, CFAI vol 4) … and are avoided by some investors when i-rate decline. However, when properly managed by separating mortgage valuation decisions from decisions concerning the appropriate duration of the portfilio, mbs are not market-directional. Q: what is the above saying? - sticky
It sound’s like - is light a wave or a particle? 
Sounds like stupid trader speak to me. There is some statement there that the analysis of the quality of the underlying collateral done “properly” can be so powerful as to remove concerns about duration from the investment decision. I always hear stuff like that from idiots in expensive suits who don’t like my ensuing sarcasm.
so … this statement from the CFAI textbook is bullshit? - sticky
I dunno it falls in the same category as “If an analyst is good at understanding a company’s underlying value, the direction the market takes is not important” or “A good trader doesn’t need to have an exit plan. When he enters the position, he knows where the market is heading” and all that other macho idiot BS.
I read that chapter too. Here is my understanding…compare to a bullet bond, due to the negative convexity of MBS, when rate is going down, MBS will underperform compare to bullet bond(when rate go down, value “go-down”), whenrate go up, MBS will do much better than bullet bond (rate go up, value “go-up”). That explaines the market directional part. However, in the chapter, they talked about few ways of hedeging the MBS, (straight treasury, 2 bond hedge, and 2-bond hedge with options), I thing the key point was to NOT hedege the spread risk(source of return). Once it is properly hedged, then MBS is not market directional. HELPS??
ws Wrote: ------------------------------------------------------- > I read that chapter too. Here is my > understanding…compare to a bullet bond, due to > the negative convexity of MBS, when rate is going > down, MBS will underperform compare to bullet > bond(when rate go down, value “go-down”), > whenrate > go up, MBS will do much better than bullet bond > (rate go up, value “go-up”). side-track: when rate goes up, MBS will do pretty much like a bullet bond, I suppose? We can still say that this demonstrates “market directional”. > That explaines the > market directional part. - sticky
ws Wrote: ------------------------------------------------------- > However, in the chapter, > they talked about few ways of hedeging the MBS, > (straight treasury, 2 bond hedge, and 2-bond hedge > with options), Just want to say that 2-bond hedge with options is NOT covered by any LOS - sticky
Sticky, Market direction mean value of the asset moves in the same direction with interest rate. Here is the tricky part, when you say “rate goes up”, you really have to say when “rate goes way up” (need to be out of the negative convexity area) to be acting like a bullet bond (i-rate up, value down, this is not market directional). However, when rate just go up a little (however, still in that negative convexity area), the embedded option will be less likely to be exericsed, MBS value go up (i-rate up, value up, market directional). This is little hard to explain in word, try to have that picture in your head, it will help greatly. Make sense??
gotcha regarding this. Thanks! - sticky ws Wrote: ------------------------------------------------------- > Sticky, Market direction mean value of the asset > moves in the same direction with interest rate. > Here is the tricky part, when you say “rate goes > up”, you really have to say when “rate goes way > up” (need to be out of the negative convexity > area) to be acting like a bullet bond (i-rate up, > value down, this is not market directional). > However, when rate just go up a little (however, > still in that negative convexity area), the > embedded option will be less likely to be > exericsed, MBS value go up (i-rate up, value up, > market directional). > > This is little hard to explain in word, try to > have that picture in your head, it will help > greatly. > > Make sense??
I don’t agree with ws’ definition. Market directional means when you use a simple approach (i.e. duration) to try to hedge an MBS, your supposedly hedged portfolio could end up with losses if interest rates move one way (down) and gains if interest rates move the other way (up). Your simple hedging approach doesn’t work due to negative convexity of the MBS. What that sentence is saying is that a smarter hedging approach (2-bond) will eliminate that gain/loss payoff structure, thus removing “market directionality”. The one thing that ws is spot on – picture the graph, it helps alot.
No it’s not that…although that is sort-of true, that sentence doesn’t say anything close to it.
I formulated my “definition” based on what CFAI readings said – Vol 4, page 70.
ws Wrote: ------------------------------------------------------- > Sticky, Market direction mean value of the asset > moves in the same direction with interest rate. > Here is the tricky part, when you say “rate goes > up”, you really have to say when “rate goes way > up” (need to be out of the negative convexity > area) to be acting like a bullet bond (i-rate up, > value down, this is not market directional). > However, when rate just go up a little (however, > still in that negative convexity area), the > embedded option will be less likely to be > exericsed, MBS value go up (i-rate up, value up, > market directional). > MBS value goes up when rates go up by a little bit when the pre-payment option is in the money? That makes no sense… That’s making the assumption that the value of the option changed by a greater amount than the security itself as a result of the int. rate increase… Am I missing something here? > This is little hard to explain in word, try to > have that picture in your head, it will help > greatly. > > Make sense??
Also… by MBS being market directional, what do they mean exactly? I see a few posts above and the only one that made somewhat sense was how in relation to bullet bonds, it’s market directional: ie: Interest rates drop, MBS will underperform Bullet Bonds. Interest Rates increase, MBS will be inline with or outperform Bullet Bonds - hence they are market directional?
By “Market Directional” they mean that MBS should only be considered when rates are expected to rise, because of their negative convexity which will cause them to underperform in declining interest rate environments. However, if effectively managed , MBS can be good in either interest rate environments, but this requires proper hedging.
Cool… makes sense. Now if I could just wrap my head around the hedging strategy for MBS.