Yield on MBS = yield on T sec + Spread.
Here Spread is sum of option cost = cost of bearing prepayment risk + OAS - compensation for bearing the remaining risk (i.e. spread risk, volatility risk, model risk, interest rate risk)
1)Now Spread risk - usually not hedged coz that is the whole purpose of investing in MBS.
Int rate risk = hedged by selling T notes/futures. Now investor earns T bill + Spread (#1 mentions it is not usually hedged)
Model risk - can not hedge.
Prepayment risk - now what I understood is when int rate increase, prepayment period extends (i.e. like in a floating mortgage loan - if interest rate increases & you don’t wish to change ur monthly mortagage cost (EMI) your tenor increases in amortization schedule). When interest rate decreases, prepayment period shortens.
This means that mortgage duration is increasing (i guess due to increase in prepayment period) when interest rate increases & mortgage duration decreases when int rate decreases. This is against our desire. I mean we would like duration to increase when int rate goes down (to make it more sensitive to int rate to capture larger gains) & duration to decrease when int rate goes up (to loose less). To hedge we need to buy options or hedge dynamically. Hedging dynamically will require us to to increase duration (buy futures) when rates decline & decrease duration (selling futures when int rate increase. )
- Volatility risk - now option has feature of increase with increase in volatility & vice versa We have sold prepay option. I think now when volatility increases, option cost increases. Since we are short on option, effect to us is opposite. So OAS tends to widen with increase in volatility. We can hedge volatility again by buying options or hedging dynamically.
Let me know if i am wrong somewhere.