CFAI book 4, page 167. Why would “separating mortgage valuation decisions from decisions concerning the appropriate interest-rate sensitiity(duration) of the portfolio” make the mortgage securities not market-directional?
it is my understanding that by separating the valuation decision from the duration decision you are in essence hedging the portfolio by matching duration of the portfolio to its target
The value in a mortgage security comes from estimating a true spread over what the market is suggesting it is. We’re really trying to capture a spread difference. It should not matter to the spread if rates change since the investment is made . We do not try to hedge out the spread , only the prepayment option ( which is the market-directional part). The prepayment option is very sensitive to the level of interest rates . If we hedge it away , we capture the true spread difference , which is what our intention is.
Thanks, janakisri. So the market-directional is the interest-rate-directional? And the investors of mortage securities are making money by taking the [mortgage] spread risk?
In fixed income , market means interest rate. And yes , the intention is to earn the spread at an appropriate level of risk , but hedge against rate declines that could affect the price due to prepayments