The statements in last paragraph : Hedging dynamically requires lenghthening duration - lenghthening duration - buying futures - “after” rate has declined. and shortening duration - selling buying futures - “after” rate has risen. Is it that following shall be correct ? lenghthening duration - buying futures - “before” rate has declined shortening duration - selling buying futures - “before” rate has risen.
Your reasoning is correct. Dynamic always means accounting for change.
Any other comment ?
Prepayment option will cause DUR to change at undesirable way (-ve convexity): After interest rate fall => DUR shorter than expected After interest rate rise=> DUR longer than expected To offset the change in DUR. we can hedge dynamically with futures. After interest rate fall=> lenghthening duration - buying futures After interest rate rise=> shortening duration - selling futures
derswap07, Comments from B_C make sense to me, so statements in CFAI text shall be correct. B_C, TKVM for your clarification.
B_C, I have some confusion with regards to your statements. After interest rate falls (which means, prices have risen), why would you want to lengthen your duration? Wouldn’t it be the other way around? To shorten it? This is so that sensitivity is reduced if interest rates start to rise again. The opp. for when interest rates rise…lengthening duration instead of shortening? Pls. clarify on this. Thanks
Your aim is to hedge prepayment risk and not to exploit yield curve changes. After interest rate falls => MBS price rise but less then other noncallable bonds/treasuries due to negative convexity of prepayment option. (ie. DUR of MBS shorten, less sensitive than it was before), you want to offset the DUR changes, so you lengthen the duration by buying futures to increase the sensitivity.
B_C, Sorry, I come back here as I am confused again. To avoid the increse in value of MBS that is less than other noncallable bonds/treasuries , is it better to lengthen the duration before I/R falls ? i.e., if the duration of the MBS is lenghthened before I/R falls, then the increse in value of MBS can be comparable with that of other noncallable bonds/treasuries ?
Gotcha…didnt look at it from that perspective ! All clear now… Obviously this is only applicable to MBS right, or any FI with an embedded option (call in this case).
Maybe I am thinking too much into this. I think there can be two scenarios. While interest rate is falling and after it falls 1) While interest rate is falling: Obvious thing to do is increase duration, so that price rises more quickly than before. I hope no issues here. 2) After interest rate falls: You want to reduce sensitivity by reducing duration because once interest rates start rising, you don’t want prices to fall as quickly. I am confused at to which of the above scenarios is applied in your problem. I am guessing by the looks of it that it is “while interest rate is falling.” What say?
AMC, The problem is that how do you know the interest will rise or fall? If you lengthen the MBS DUR and expect the interest to fall. You will lose more if interest rise. Aims of hedging is to reduce risk and not to increase it.
B_C Wrote: ------------------------------------------------------- > AMC, > > The problem is that how do you know the interest > will rise or fall? If you lengthen the MBS DUR and > expect the interest to fall. You will lose more if > interest rise. Aims of hedging is to reduce risk > and not to increase it. Yes, the key point is I/R will rise or fall. There are 4 scenarios : 1. If you lenghthen duration after I/R fall while after that A. actually I/R rise => price will fall more than not-lenghthening B. actually I/R fall further => price will rise more than not-lenghthening 2. If you shorten duration after I/R rise while after that A. actually I/R fall => price will rise less than not-shortening B. actually I/R rise further => price will fall less than not-shortening Since no indication of the scenario in the CFAI text, thus I think those statements are questionable. If I am wrong, just correct me !
sparty419, Aims of hedging is align risk exposure to a target level. Even if you can correctly predict the interest rate direction, the amount of change may not be the same as what you expect. Just like rebalancing, you could rebalance to the original DUR. or rebalance to a DUR different from original to exploit the market changes. If you want to hedge risk, you rebalance to original DUR. If you want to exploit market opportunity you could rebalance to different level for higher expected return. But the latter is not hedging.
B_C, I agree that if the goal is hedging and the durations shall be adjusted back (rebalanced) to its original DUR. So those statements are not questionable. TKVM !