SS10: r26: Q4: hedge volatility : when implied vol is high or low

CFA Level III
#1

SS10: r26: Q4: hedge volatility : when implied vol is high or low

page 190:

what is the reason to use different way to hedge when implied vol is high or low:

implied is higer and expectation of future vol will be low: dynamic hedging

impiled is low and expected is how: option

what dynamic hedging here refer to? Thanks.

#2

Dynamic hedging usually makes frequent adjustment to the number of contracts. Here it could refer to selling options, but it may also refer to hedging with futures.

Source: glossary of curriculum.

#3

^ yes, but i have the feeling they are referring to the 2 bond hedge in dynamic hedging here

#4

IMO

There are comparing IV reflecting in the option prices to expected to be realized in future

So if IV is lower than than the future realized volatility - Buy options to hedge

here implied volatility is low as reflected in option prices. Meaning option prices are lower now & expected to increase with increase in volatility as the time goes on.

If IV is higher than the expected future volatility - hedge dynamically.i.e adjust no of contracts future contracts

IV is high —so option prices are high—expected to go down. One way to profit from it would be to Sell the option…but since you are already short on option on MBS, one can only buy options or buy/sell futures.

??

#5

A follow-up question:

What type of options to buy if the implied volatility is low?

#6

Text does not specifically mention this.

IMO, this should be Call option whose value increases with increase in volatility.

#7

.

#8
#9

Sir!

Manager is looking to manage the volatility risk here not the interest risk. This is how i interpreted it. I could be wrong though…

#10

Reduce Vega Dollars.

#11

Isn’t the appropriate volatility in this case interest rate volatility? The hedge is on mortgage backed securities, so the options are interest rate options and the appropriate risk is then interest rate volatility risk, correct?

#12

“Dynamic hedging” here means using a spot product (like stock or futures) to delta hedge the option. I think what this text is saying is:

  1. If implied volatility is high and expected future volatility is low, use delta hedging as opposed to buying options as a hedge. You don’t want to buy options because the high implied volatility makes them expensive.

  2. If implied volatility is low and expected future volatility is high, buy options, since the low implied volatility makes them expensive.

The text in the original post is kind of vague. We can probably give you a more confident answer if you give us more details. For instance, what are you trying to hedge? Long or short? etc.

Both calls and puts have positive vega, by the way.

#13

I agree more pertinent volatility is Interest rate volatility.

There are few things I tried to interpret here

  1. Like other risks, MBS has volatility risk. If investor is long the MBS, by virtue of it, he is short on prepayment option. Thats is if interest rate goes down, homeowners will prepay their liabilities.

Now I am trying to interpret the effect of volatility which is

Increase in volatility----> increases value of options (as we have learnt in option pricing theory.)----> since its short it should decrease the MBS value

So now to hedge against this downfall I would like to either use option or hedge dynamically.

Comes the questions when would like to use futures or options. Now the text says, If implied volatility is low (somethings which I remeber from L2 from black scholes model) is low however expected to increase in future (i.e. future realized volatiltiy would be higher)…I would buy options. Which options? IMO call option.

  1. If IV > future actual realized volatiltiy, currently due to high implied volatiltiy (option price is high) which would go down as we move along. One way we can profit from it would be to short option. Since we are already short on our investment (MBS) we would rather like to hedge dynamically (i.e. thru futures)

  2. Effect of volatility on OAS

  • OAS widens when volatility increases to comensate the MBS investor (I had to memorize it as text says). However i thought generally OAS which is adjusted for option price.( i.e. OAS = spread - option cost) should contract when volatility goes up. Since option cost is high we deduct more value hence low OAS)
#14

Low implied volatility makes options IN-expesive (cheap).

Are we still talking about hedging mortgage backed securities here? I don’t remember the material talking about using dynamic hedging for these. It makes sense when you would use one over the other, I just don’t see where it mentions this in relation to hedging the MBS.