If the price is below par for a mortgage security, then the price is more likely to exhibit positive convexity, and a duration-based hedge will be more effective. Can someone please explain? thanks!
First of all, when is the a bond priced below par? When the interest rates are above the coupon rate of the bond (mtg rate for MBS). When interest rates are above the inherent mortgage rates that make up a MBS, the homeowners will not be able to refinance into lower interest rate mortgages. So the prepayment option decreases in value and the bond acts more like traditional non-callable debt in that it has positive convexity for small interest rate changes. Duration based hedges are more effective for noncallable bonds which exhibit positive convexity. Otherwise, you would need to produce two hedges. One for the positive convexity portion of the bond pricing curve and one for the negative convexity portion.
Wow good explanation
McLeod81 Wrote: ------------------------------------------------------- > > Duration based hedges are more effective for > noncallable bonds which exhibit positive > convexity. Otherwise, you would need to produce > two hedges. One for the positive convexity > portion of the bond pricing curve and one for the > negative convexity portion. I assume you mean duration hedge good for parallel shift, and not good for twist while two bond hedge is good for both.