Under stable interest rate environment, you sell convexity by selling put and call options of bonds you are willing to buy and sell.
Under volatile interest rate environment, you buy call option on the bonds.
Now my question is how MBS comes into the pic. DO you buy MBS if you expect stable and sell them for volatile?
Thanks,
MBS is short convexity. So it performs best in a stable rate environment.
Wlfgngpck has it right.
In the absence of the ability to sell options per constraints, you can also purchase callable bonds which have an embedded short option to lower convexity and increase yield.
MBS is like a callable bond by its characteristics due to prepayment risk. Also exhibits a negative convexity in low IR environment.
IMO, no rule of thumb. You might rather change the trading strategy in a volatile environment like from bullet to barbell.
Regarding MBS, it might depend which tranche you are long or short.
I was assuming he meant a production coupon pass through. Certainly you can tranche things in a way to get different prepay treatments, but generally MBS are short convexity unless you either 1) are deep in the money, 2) are deep out of the money, or 3) are tranched in a way to give VERY favorable prepay treatment.
In my opinion, 3 points to remember
1/Call, Put options have positive convexity.
Callable has short call => have negative convexity, Putable has long put => have positive convexity, MBS has negative convexity
2/ If volatility increases, having positive convexity is good. If volatility decreases, not necessary to have positive convexity, so should monetize the positive convexity by reducing the convexity.
3/ If you want to increase (resp. decrease) the convexity, should purchase (resp. short sell) products having positive convexity or short sell (resp. purchase) products having negative convexity
MBS perform better in a stable IR environment because if rates decrease, they are more likely to be repaid (CPR increases when rates are low); and if rates go up, they will decrease in value just like any other bond. Thus, they have negative convexity
They do have a negative convexity as I wrote above.
I do not agree in full with the first sentence. This depends on particular tranche.
Recommend:
Could you elaborate on the two statements in point #1?
Why do call and put options have positive convexity? I know the relationship between call/put option’s price and interest rates, but how do I get from that to convexity?
Secondly, I understand, callable bonds have negative convexity (only when rates are low) and puttable bonds have positive convexity (higher than straight bonds when rates are high), but what do you mean by “Callable has short call” and “Putable has long put”?
Could you elaborate on the two statements in point #1?
Why do call and put options have positive convexity? I know the relationship between call/put option’s price and interest rates, but how do I get from that to convexity?
Secondly, I understand, callable bonds have negative convexity (only when rates are low) and putable bonds have positive convexity (higher than straight bonds when rates are high), but what do you mean by “Callable has short call” and “Putable has long put”?
For the 2nd question, callable = straight bond - call option and puttable = straight bond + put option. So callable has short call (-call option) and puttable has long put (+put option).
For the 1st question, just to make things simple, when you draw a function, geometrically if the curve of the function heads to the abscissa, the function has positive convexity (this method is easy to use IMO). So, call and put have positive convexity (you can demonstrate the positive convexity from the function of call, put prices but this method is more complex).
Was this for me? If yes, I’m all set in MBS. 