Why mortgage securities are "market-directional" investments?

Why mortgage securities are “market-directional” investments?

And why the two-bond hedge is not market-directional investment?

Its because mortgage securities exhibit negative convexity.

When interest rates decline, prepayments cause the value of the MBS to increase less in value than that of a Treasury position with the same initial duration. Thus, when interest rates decline, simply matching the dollar duration of the Treasury position with the dollar duration of the MBS will not provide an appropriate hedge when the MBS exhibits negative convexity.

For this reason, many investors consider mortgages to be market-directional investments that should be avoided when one expects interest rates to decline.

Since two factors (the “level” and “twist” factors) have accounted for most of the changes in the yield curve, two Treasury notes (typically the 2-year and 10-year) can hedge virtually all of the interest rate risk in mortgage securities.

sorry but why are they called market-directional?

And are the two bonds in the two-bond hedge mortgage securities?

The two bonds are Treasuries, a short term and a long term treasury to be specific.

MBS’s are called market directional because if you hedge using only one treasury the hedge does not always perform well depending on the direction (up or down) of the market.

If interest rates increase the value of your hedge will gain more than the loss on your MBS (average investors don’t care if it’s a perfect hedge if they gain on the position). If interest rate decline the value of the hadge will lose more than the MBS gains.

Take a look at the two tables on Page 180 (V5).

1, Using duration hedge ( long MBS, short Treasury Futures): – If interest rate goes down, the hedged portfolio has a loss. – If interest rate goes up, the hedged portfolio has a gain. This makes MBS market-directional. 2-bond hedge will make it not market-directional.

2, Are the two bonds in the two-bond hedge mortgage securities? – No, they are Treasuries or Treasury Futures. I don’t think you can short MBS.


“Market directional” seems pretty vague, but it sounds like the “market” here is just interest rates. Or bonds - rates and bonds are obviously related. If rates move in one direction, MBS prices will obviously change. A two bond hedge is supposed to be insensitive to yield curve shifts. The point of a two bond hedge is to change your “twist” exposure without affecting your risk from parallel shifts. So, the value of a two bond hedge does not react to rates changes in the same way as MBS.

You can short MBS. In fact, you can do any imagineable trade with anything if you find a counterparty to trade with you.

so the two-bond hedge is composed of - for example- 2 year and 10 year treasury notes. I think in this portforlio 2 year note would have larger proportion. The reason is in order to hedge a mortgage security, the interest rate decrease would cause a lower extent of price rise due to negative convexity when interest rate decline, a portfolio composed of more 2 year note(increase less when interest rate decline) and less 10 year note would meet this demand, is this true?

Not necessarily. We need to use the equation to determine the proportion in 2 Yr & 10 Yr Treasury notes.

I also think that we can ONLY use 2 yr & 10 yr Treasury Notes futures under two bond hedge coz only this combination - on average has the same price performance as MBS to be hedged for “level” & “twist” yield curve scenarios.

ALSO assumptions are imp for having a two bond hedge.

Reading 26 has demostrate, explain, contrast and compare LOS. Hope ther won’t be any calculate question on two bond hedge. What you say?

what is the problem with solving a 2 var. simultaneous eqn?

u find that difficult?

better that than least likely most often never felt but seen crap

Two bond hedge equations are important & has appeared few if not many times in exams.

Which years in AM?


By the way, secret sauce(p153) tells that negative convexity is why an unhedged mortgage security is called a “market directional” investment.