volatility risk of MBS

Reading Vol 4, p54: In analysis of volatility risk of MBS, the reading says manager should hedge dynamically if she believes future volatility will decrease. What is “hedge dynamically”? And how does it work? Thks !

it means close out a portion of your position if it starts to move against you. “hedging dynamically” means hedging w/o options.

Buckhead Wrote: ------------------------------------------------------- > it means close out a portion of your position if > it starts to move against you. “hedging > dynamically” means hedging w/o options. I am going to have to disagree. It simply means that the hedge will have to be adjusted as the price of the underlying moves. Options may or may not be used, but some sort of contract must be. A static hedge is one where the hedge is made at initiation, and no rebalancing needs to be done throughout the investment horizon. You can’t delta hedge a stock today and expect that hedge to continue to work after 2 months have passed and the underlying has moved 10%. Thus delta hedging is often done dynamically.

I am also confused by this issue. Why dynamic hedging shall be done if future volatility will decrease ? And what action shall be taken if future volatility will inecrease ? What are the rationales ?

i can answer the second part of your question. if volatility is low, the value of the option inherent within a MBS is low so the strategy would be to buy a call option to capitalize on the increase in the value of the option as volatility increases. Recall the value of a call increases with volatility. Because the value of the MBS = (MBS - value of call option), the gain from the call option offsets the reduction in the MBS caused by the increase in the call option. You are in essence hedging against negative convexity.

I agree with jmy and would have agreed with wyant but I’m less sure about that after reading the text (btw, it’s page 154, not 54 of V4). I still think that’s right, but I agree that the text is a little ambiguous.

so the question is 1) why; and 2) how do you dynamically hedge when volatility is high but expected to come down. anyone?

wyantjis is one to something. The curriculum makes 2 references to “dynamic hedging”. This first is in volume 4, page 154, in reference to hedging MBS. There, “dynamic hedging” is the discrete counterpart to buying options – the material then goes into describing the 2 bond hedging method. So for MBS, “dynamic hedging” is hedging w/o using options. But in volume 5, page 282, “dynamic hedging” is discussed in conjunction with “delta hedging”. So I don’t think my original answer is completey correct in terms of the CFA material, but in reference to MBS, “dynamic hedging” does mean hedging w/o option usage.

I agree with Buckhead that the curriculum made it sound like Dynamic Hedging is hedging without option . Also as I remember it you would use Dynamic heding when the volatility implied by the option price is greater than the expected volatility. If the volatility implied by the option price is lesser than the expected volatility then you hedge using options/ I took that too mean Implied volatility of the option is higher than expected volatilty ==> option is overpriced (because option prices increaes with volatility)==> hedge dynamically. Implied volatility of the option is lower than expected volatility==> option is underpriced ==> use options.

right, but how do you hedge dynamically?

Hedge ratios change over time and as rates move (among other things). Your initial hedge is typically only good until rates move. So to hedge dynamically, in this sense, is to adjust the amounts of T’s held (and possibly the direction of the position) against the MBS position you are trying to hedge. To quantify this you would have to go through the whole 7 step process outlined in the CFAI text.