Can someone ecplain this clearly
because you can hedge MBS and just earn the spread risk
Rf + spread risk
when the valuation decision and the interest rate risk decision are separated, they are not market directional. You can hedge rate risk and earn spread, as iteracom said.
Why do you put ‘NOT’ in the question? MBS is market directional due to its negative convexity; properly hedged MBS is not market directional.
MBS are popularly thought of as market directional. However the author of the reading clearly states that they are NOT because the portfolio manager should make two separate decisions. Whether the security is undervalued and whether to hedge interest rate risk.
I lit, hedge MBS and just earn the spread risk. Thanks
MBS are market directional if you hedge them on a simple weighted average duration basis. Due to negative convexity they are affected heavily by the twist, unparallel changes in duration. So if you use two bond hedge the twist will cause MBS behave as any other bond. Aditionally, cupsy coupon bonds are very sensitive to minor interest changes and averaging change is not effective, to hedge them closely we need to use some options. Bottom line:
Non-MBS --> Simple weighted average duration match
MBS --> Two bond hedge
Cupsy-cupon --> Two bond hedge and options.