The learning outcomes d. stated : compare and contrast duration-based approaches with interest rate sensitivity approches to hedging mortgage securities. What are the “duration-based approaches” and “interest rate sensitivity approaches” ? I can not find these two terms in this reading ! Anyone can help ?
I believe they are referring to hedging using duration versus key rate duration. Because of negative convexity and the fact that MBS don’t have a bullet payment, regular hedging based on duration is no good since it will lead to losses when rates fall, so key rate duration is more important an the convexity needs to be taken into account. Think of “duration-based” as all of the hedging strategies you have read about and “interest rate sensitive” as the strategy in the reading.
“Interest rate sensitivity measure (not approach)” is mentioned on CFAI text V4 P.174, and it stated "Since two hedging instruments (two treasuries, typically the 2-year and 10-year), the hedge is referred to as a “two-bond hedge”. Therefore, I think the “two-bond hedge” shall be the so-called “Interest rate sensitivity approach)” , do you think so ? “Duration-based approaches” is not clearly defined in this reading and oOther statements are vague regaring this in this reading ! Anyone else can clarify ?
Right, the two bond approach is interest rate sensitivity. The duration approach is discussed on pg. 167. It’s the basic dollar duration hedge from an earlier reading.
Now, my question is : what is the best answer to this learning outcomes statement ?
Hedging mortgage securities with typical duration-based approaches are insufficient, since mortgage securities have negative convexity due to the prepayment option and lack a bullet payment at maturity. Standard duration approaches will result in losses when rates drop due to the negative convexity and the duration of mortgage securities will be inaccurate since the securities will be more susceptible to twists in the yield curve than a standard bond since the payments are evenly spaced over the yield curve rather than concentrated at one point. The preferred method of hedging a mortgage security is to focus on interest rate sensitivity approach. A two bond hedge will address the problems inherent in the mortgage securities interest rate sensitivity to the shape of the yield curve.
I was generally okay with the theory in Reading 31, but does anyone know if we have to be able to actually construct a two-bond hedge for the test? Schweser seems to think we won’t, but the text seems to go to great effort to tell us how to do it.
notenoughtheta Wrote: ------------------------------------------------------- > Hedging mortgage securities with typical > duration-based approaches are insufficient, since > mortgage securities have negative convexity due to > the prepayment option and lack a bullet payment at > maturity. Standard duration approaches will result > in losses when rates drop due to the negative > convexity and the duration of mortgage securities > will be inaccurate since the securities will be > more susceptible to twists in the yield curve than > a standard bond since the payments are evenly > spaced over the yield curve rather than > concentrated at one point. The preferred method of > hedging a mortgage security is to focus on > interest rate sensitivity approach. A two bond > hedge will address the problems inherent in the > mortgage securities interest rate sensitivity to > the shape of the yield curve. notenoughtheta, TKVM !
monger187 Wrote: ------------------------------------------------------- > I was generally okay with the theory in Reading > 31, but does anyone know if we have to be able to > actually construct a two-bond hedge for the test? > Schweser seems to think we won’t, but the text > seems to go to great effort to tell us how to do > it. We had to last year on the exam (or a practice exam, can’t remember) and schweser said it as a remote chance then too.
That’s probably why they put it on the exam. I always get nervous when I read something in Schweser that says something along the lines of: “CFA Institute loves to test this material.” Okay, I know not to expect that on the exam now…
notenoughtheta Wrote: ------------------------------------------------------- > Hedging mortgage securities with typical > duration-based approaches are insufficient, since > mortgage securities have negative convexity due to > the prepayment option and lack a bullet payment at > maturity. Standard duration approaches will result > in losses when rates drop due to the negative > convexity and the duration of mortgage securities > will be inaccurate since the securities will be > more susceptible to twists in the yield curve than > a standard bond since the payments are evenly > spaced over the yield curve rather than > concentrated at one point. The preferred method of > hedging a mortgage security is to focus on > interest rate sensitivity approach. A two bond > hedge will address the problems inherent in the > mortgage securities interest rate sensitivity to > the shape of the yield curve. notenoughtheta or anyone else, Sorry I come to this issue. My questions are : 1. Assume that I/R falls A. To hedge the I/R risk of parallel yield curve shift, shall we hedge by shorting (selling) Treasury futures ? B. To hedge the I/R risk of non-parallel yield curve shift, shall we hedge by shorting (selling) Treasury futures ? C. If shorting (selling) Treasury futures is not appropriate, what is the best way of hedging ? 2. Assume that I/R rises A. To hedge the I/R risk of parallel yield curve shift, shall we hedge by shorting (selling) Treasury futures ? B. To hedge the I/R risk of non-parallel yield curve shift, shall we hedge by shorting (selling) Treasury futures ? C. If shorting (selling) Treasury futures is not appropriate, what is the best way of hedging ? 3. In above scenarios, is it that market I/R > coupon rate and/or market I/R < coupon rate relevant ? Thank you in advance !