WTF - Sample Exam2 Problem 11

cfacfacfa Wrote: ------------------------------------------------------- > i thought the decision whether to buy or sell is > dependent upon the expected direction in rates Yes, thats right. You are either buying or selling because of the convexity gap

ws Wrote: ------------------------------------------------------- > Yes, given the choice. Future or option. Furture > will be a little cheaper. If you guys are telling me that CFAI asked this question to see if I know what is cheaper Futures or Options, I’m going to lose it. Why on God’s green earth would they bring in implied and expected volatility to test me on this???

Implied vol is dervied from options prices. Higher implied vol - higher option prices.

I understand the implied and expected volatility part. Not sure when do you have to buy/sell options and when do you need to buy/sell futures

comp_sci_kid Wrote: ------------------------------------------------------- > Implied vol is dervied from options prices. Higher > implied vol - higher option prices. I think this is why everyone is getting messed up on this then. People are confusing implied with expected! They do seem to mean the same thing though!

If decided to hedge dynamically -> will use futures. Since need to increase duration -> will buy futures.

I’m with Bigwilly, I thought to delta hedge the risk by selling options since volatility was going to decrease in the future… Foxie, volatility is not priced into futures. I think that’s where your confusion is.

hey bpl1000, usually they don’t, but for MBS I think they do! Sell options won’t hedge, only buy option hedges call sold.

okay did this test yesterday - - was part of this thread and still missed the question - - having trouble reconciling the hedge of a long MBS position by going LONG treasury futures. I get the point about staying away from options here - current vol is high and going down therefore value of your option will decrease - - so stick to dynamic hedging but if i’m long the mbs position, why do i want to increase my duration by going long the futures? interest rates go up, my MBS security value falls (but not as much as a treasury would) and the value of my futures dropped as well - - i obviously chose the option of selling futures - - just can’t wrap my head around it and i’ve looked at cfai and schweser and can’t piece it together

Think of it as hedging convexity. When everything will become clear

hedging convexity by increasing duration? what am i missing when i think: okay, i’m long an MBS contract - interest rates increase and my value goes down - - now, i’ve hedge by going LONG treasury futures, so the increase in rates has just decreased the value of my futures position - - what exactly have i done that was hedging here? even with the 2 bond hedge you can either short the bonds or the futures

this is how I look at it: dynamic hedging is more “expensive” you always playing a bit of catch up with them so you want to use dynamic hedging when the future volatility is expected to be lower so that you don’t have to adjust it too frequently options make money when volatility is high so you want to use them when the future volatility is expected to be higher than Implied. this question got me too…

Iwonna, the options thing is the other way round. If Future volatility is expected to be more than implied use options. Options are cheaper now.

only thing i don’t get is why go long treasury futures instead of short - - i’m already long the MBS - - doesn’t make sense to me to hedge long with long - - if int rate goes up, value of my MBS bond goes down and so does my futures position - i’ve agreed in the contract to buy the treasury at 980 say, but int rates go up and it’s now at 950 - - i’ve lost on both sides of this - - i lose my job because i hedged long with long - it’s ugly i’ve overthought something or i just have been looking at it all too long and things are moving across the page - - i don’t get this one

OK, Let me help you, it takes me sometime understand it too. This is what you need to know: " a PM should ajust for changes in the durations of an MBS-or equivalent, manage the negative convexity, by either buying option or hedging dynamically" The question now is when you have to hedge Dynamically? for the answer go to page 60 volume 4 part D ( volatility risk) Assuming you read the reference that I give you and believe that you must hedging dynamically. This how you do it “Hedging dynamically, requirer that lenghtning the duration-buying future contract- after rate have declined , and shortening the duration- selling future- after rate have risen” Otherwise, meaning if you not hedging dynamically, but still you want to hedge given your volatility situation, just buy options. Ok Hope this help you folks

cvillecfa: Do you get my answer?

ok, finally I think I got it. Volatility high -> Option high -> MBS low, no question about it. If implied volatility so high, option expensive, you don’t want to buy option to hedge. If realized future volatility low, buy such future to hedge. CilleCFA, here is the point: no one asked to buy MBS future!!! You need to buy volatility future!!!

no - - i may have peaked and i’m headed down now i understand that CFAI says that after rates have declined you need to increase duration by buying futures - - buy i still don’t understand why i’ve hedged by having two securities now (MBS and futures position) that will suffer if rates increase or improve if rates decrease - - doesn’t seem to be a “hedge” - - i would think i’d want to be short the futures so i could offset my gain/loss depending on what rates do what is the scenario where the value of these two instruments go in opposite directions - - i understand that they will move at different rates due to the convexity of the MBS - but i would think that applies to the sizing of the hedge, not the direction, i.e., long/short

foxie - - what’s a volatility future?

If you do not buy it, you duration will lower than the treasury because of the prepayment oftion associate with the MBS, your spread will be way lower. Remember also you do dynamically hedge only if you expect the volatility to be lower than what it implied. I understand your point but I the end study by heart because you will understand why after the exam, it is crunshing time. JUST ACCEPT IT!!!