Someone posted an acronym a while back to help remember the various risks associated with MBS. Anyone remember or have it? I tried searching but couldn’t find it… Thought it was something like STYLE except you replace the Y with a V but that didn’t add up…
hmm Yield Curve Risk, Interest Rate Risk, Model Risk, Prepayment Risk…
about MBS, the 2 bond futures hedge does its job when rates increase, but when rates decrease the strategy is negative, right?
also Spread Risk i think
2 bond hedge wont properly hedge if Current Yield < Coupon Yield - you are in negative convexity territory. It will do ok job when you are in positive convexity - Current Yield > Coupon Yield, again the hedge is not perfect as when optinality kicks in, all bets are off (even with positive convexity there is still effects of volatility ect)
M - Model Risk S - Spread Risk V - Volatility Risk I - Interest rate risk P - Prepayment Risk I would add Yield Curve Risk 100% too. Spread risk is there too, you are right, in particular OAS Spread risk not Z spread
NO NO NO 2 BOND HEDGE HEDGES 1) INTEREST RATE RISK 2) YIELD CURVE RISK IT DOESNT HEDGE CONVEXITY. HOW MANY TIMES SHOULD I REPEAT IT!!!
in other words, it hedges duration and non-parallel shifts?
here is the acronym, courtesy of sticky SIMPLY (but with the L changed to V) S = Spread risk I = Interest rate risk M = Model risk P = Prepayment risk V = Volatility risk Y = Yield curve risk
thanks. I was about to post that again. Good that you did not violate I(D). To add to that, my personal note here has that V in red, and written a bit twisted like an L — just to make something special with this special acronym.
the LOS talks about whether these risks can be hedged effectively…lemme add the ways of hedging these shortly for future reference… S = Spread risk ----> The manager does not seek to hedge spread risk. Instead tries to capture OAS by over(under)weight MBSs when the rates increase(decrease) I = Interest rate risk ----> Risk can be hedged directly by selling a package of Treasury notes or Treasury note futures. M = Model risk ----> It cannot be hedged explicitly P = Prepayment risk----> It can be hedge by buying Futures when rates have declined to lengthen the duration and selling Futures when rates have risen to shorten the duration. V = Volatility risk----> It can be hedged by buying options or by hedging dynamically. Y = Yield curve risk ----> 2bond hedge v duration based hedge
Awesome… thanks guys. Can someone explain the difference between a 2 bond hedge and a duration based hedge
2 bond hedge, hedges against yield curve twists (well, almost). Duration based hedge doesn’t hedge against yield curve twists.
Right… what about key rate duration matching?
again for yield curve shifts not for yield twists.
Not accurate. Page 15 of Schweser: “Where effective duration measures the portfolio’s sensitivity to parallel shifts in the yield curve, key rate duration measures the portfolio’s sensitivity to TWISTS in the yield curve.” Thought I’d throw a loop I believe the 2-bond hedge is simply a key-rate duration hedge. Someone correct me if I’m wrong please. PJStyles
2-bond hedge is a variation of key rate duration hedge, since you are only focusing on two key rate durations 2-year and 10-year In theory (I suppose), 2-bond hedge can be extended to more than 2 key rate durations. In this case it would be called N-bond duration hedge (N being number of key rate durations used). I doubt that it is used in practice though.
so for a two bond hedge i only need to know the 5 risks and basically what it is, correct? Long MBS Short two bonds of different maturities (barbell with 2 and 10 year maturity, for example) Hedges both yield curve twists and shifts because the two short bonds (or futures) have different durations. Anything else?