A mortgage backed security can be hedged by … A. Shorting a bond of equal duration B. Shorting 2 bonds, of short and long durations. C. Shorting an interest rate futures contract of same duration. Cheers 
B it is
b
Tough question. B looks deceptive because 2 bond hedge is a long and a short position (not two short positions). A does an ok job for small moves but I am going with C because of CTD optionality of interest rate futures. C
But if you hedge purely based upon the duration of one security, you will lose money if interest rates fall (due to negative convexity w/ low rates). The value of the short interest rate future contract will decrease when interest rates fall. The value of the mtg backed will rise, but not as much as the futures contract falls.
I was incorrect about two bond hedge (it does consist of two short positions). B is the answer. McLeod, interest rate futures contract is similar to a bond (confusing convention). When rates go down, both bonds and interest rate futures go up.
maratikus Wrote: ------------------------------------------------------- > I was incorrect about two bond hedge (it does > consist of two short positions). B is the > answer. > > McLeod, interest rate futures contract is similar > to a bond (confusing convention). When rates go > down, both bonds and interest rate futures go up. True, but they were short int. rate futures (like short bonds). I believe caps and floors are the only interest rate derivatives which move with interest rates right?
http://www.answers.com/topic/interest-rate-futures-contract Futures contract based on a debt security or inter-bank deposit. In theory, the buyer of a bond futures contract agrees to take delivery of the underlying bonds when the contract expires, and the contract seller agrees to deliver the debt instrument. However, most contracts are not settled by delivery, but instead are traded out before expiration. The value of the contract rises and falls inversely to changes in interest rates. For example, if Treasury bond yields rise, futures contracts on Treasury bonds will fall in price. Conversely, when yields fall, Treasury bond futures prices rise. There are many kinds of interest rate futures contracts, including those on Treasury bills, notes, and bonds; Government National Mortgage Association (GNMA) mortgage-backed securities; municipal bonds; and inter-bank deposits such as Eurodollars. Speculators believing that interest rates are about to rise or fall trade these futures. Also, companies with exposure to fluctuations in interest rates, such as brokerage firms, banks, and insurance companies, may use these contracts to Hedge their holdings of Treasury bonds and other debt instruments or their costs of future borrowings. For a list of interest rate futures contracts, see Securities and Commodities Exchanges.
Still, short interest rate futures move contrary to bonds and gain value when interest rates fall because they (because they are sold).
CFA book says shorting treasury or future will work for interest rate risk. But for a non-parallel shift, two bond hedge is needed. However, it may not be always shorting two bonds. It depends. Please comment. GetSetGo, what is the suggested answer.
I would say B as well
The proposed answer was supposed to be B. It is not even B, to hedge an MBS depending on the numbers we may have to go long a short term bond and short a long term bond, or short both short term and long term bonds. It depends on the proportionality of numbers in the equation. I apologise for the lack of clarity.
Yeap B
poor question again, GetSetGo
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