I agree more pertinent volatility is Interest rate volatility.
There are few things I tried to interpret here
- 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.
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)
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)