Can you please list the MORTGAGE SECURITY RISKS? How to hedge the prepayment risk(rate has risen/fallen)? This is just a review exercise, but we may find something to clearify.

Mortgage securities risks: 1) Spread risk: Generally not hedged 2) Interest rate risk: Investor will need to sacrifice some of the spread to hedge using treasuries (2 bond hedge anyone?) 3)Prepayment risk: 4)Volatility risk: 5)Model risk: Can someone help out with hedging #3 - #5??

  1. can tie prepayment risk to rate risk risk (eg rates down, pp risk up) and take a position in a relevant rate option. 4) you can attribute an amount of the vol risk to rates vol, and again take a position in a relevant instrument (vanilla option, vol swaps etc). the component that really relates to collateral quality, you can’t really hedge. you could take a position in a related index (cmbx/primex) (essentially a credit vol) but the market is thin, and its not a great hedge against vol (more a hedge against the collateral quality itself, ie a delta hedge) 5) no hedge

also 2) swaps to hedge any floating coupons

Thanks. Re: MBS Risks Posted by: volkovv (IP Logged) Date: May 31, 2008 12:50AM 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