MBS Risks

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



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). :slight_smile: 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 :slight_smile:

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? :slight_smile:

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 :slight_smile: 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?