Let’s say I expect a decrease in volatility and interest rates go up, can someone explain how to hedge this and why? (i.e. dynamic hedging, selling forwards – why would I sell forwards???) Thanks.

If you expect vol to go down => sell options interest rates to go down => sell bond puts, bond futures puts, payer swaptions, etc…

lower volatility means you won’t want to hedge with options as those options aren’t worth as much now, so you’ll want to dynamically hedge with futures. if you have a long position in an underlying, you hedge by selling futures.

you need to sell forwards. 2 reasons. First, you need to shorten duration because as iterest rates go up MBS duration increases, sou you want to shorten it. To shorten it you can *IR call options *T-bill put options *Sell T-bill forwards which also will give Since your expected vol < implied vol, your option value will decrease as implied vol will be less then expected vol, so you dont want to hold options in this situation So you want to Sell forwards

thanks for the input guys… really cleared things up for me…

what SS / reading is this frm again ?? is this derivatives or Fixed income ? I just realised i need to review this again

-Striker- I thought Lower volatility (current) < future, means, you would want to hedge with options because they are not as expensive? (i.e. the prepayment option isn’t as valuable?

Almo, If Expected Vol > Implied Vo (volatility implied from Option prices) it means that Options could be viewed currently as Cheap, b/c if Vol does increase the option prices will increase and thus can be sold at a gain

And since implied vol is almost certainly greater than expected vol (because options work that way), if you expect actual vol to decrease you should almost surely be selling options.

ok, rough around the edges…but, I think I was along the same lines… i.e. the current (lower) implied volatility < Expected (future) volatility means options not as expensive (therefore cheap) therefore use options, price goes up, and profit. thanks.

CFAI Sample #2 has this question. Their explanation was to use dynamic hedging if current implied volatility > expected. In this case, lengthen duration after a decrease in interest rates by buying futures. I answered hedge using options and got it wrong…lame.

the second sentence is the tricky one, at least i don´t understand it ok to the volatility reason and options being cheap or expensive (regardless of the difference between implied volatility and historical volatility), but I don´t see why buying futures when interest rates have gone down and viceversa This is one of the things I will memorize

hala_madrid Wrote: ------------------------------------------------------- > the second sentence is the tricky one, at least i > don´t understand it > > ok to the volatility reason and options being > cheap or expensive (regardless of the difference > between implied volatility and historical > volatility), but I don´t see why buying futures > when interest rates have gone down and viceversa > > This is one of the things I will memorize The reason is to hedge negative convexity, when IR goes down negative convexity kicks in and your duration is less then you want it to be, so you buy futures to extend the duration and vice versa

makes sense, thanks CSK

let me see if I can give a brief synopsis; if interest rates are rising, because we are long the MBS/asset we want to short; to hedge to protect the value of the MBS. however, we do not hedge the spread risk away. why? because that is the reason for holding the MBS…the additonal yield now, In regards to interest rates falling, to help keep in check the nonlinear (negative convexity) movement of the MBS, we would short 2 futures. (note; one could turn out to be a long future/bond that we’re using as well to hedge) now… In regards to dynamic hedging. (and I’m not sure what the difference is between this and a 2 bond hedge?)…i.e when to use this? other then protecting our portfolio AFTER an interest rate change… if interest rate volatility > expected interest rate volatility, the volatility has made the prepayment option more valuable to the option. hence we would not use options to hedge, but instead futures. we would long/short futures depending on the direction we expect of interest rates then, we are saying that if interest rate volatility is < expected interest rate volatility we would long options (because options value has not incorporated increase in volatility in it’s price yet) we would long calls or puts depending on which direction we expect of interest rates. i.e. interest rates falling, long a call on a bond. (is this scenario considered dynamic hedging as well?? I don’t think so?) that’s what I have so far…any revisions?