I am sorry to repeat this message since I was suggested to break down my questions posted before. Please refer to V4 of CFAI text. 1. 2nd pargraph on P167 …, many investors consider mortgages to be “market-directional” investments … Can any one clarify the actual/clear meaning of “market-directional” ? 2. P180 Why the Duration Hedge (refer to 1st table on 180) is market-directional and the Two-Bond Hedge (refer to 2nd table on 180) is not market-directional ? How to judge ? Your help will be appreciated !
I am not sure if this could help as I haven’t read this chapter yet but in terms of risk nature, directional risks by definition involve exposures to the direction of movements in financial variables, such as stock prices, interest rates, exchange rates, and commodity prices. Nondirectional risks involve the remaining which consist of nonlinear exposures and exposures to hedged positions or volatilities. For example market risk could consist of both espacially for instruments with option kind features.
The duration hedge is market directional because an increase in interest rate causes the portfolio to make money (error>0) while a decease in interest rate causes the portfolio to lose money (error<0). The two-bond hedge is non-market directional because the portfolio loses the same slight amount of money when interest rates go up and down situation. The slight losses are easily offset by the carry advantage of the MBS over treasuries. AMA Wrote: ------------------------------------------------------- > I am sorry to repeat this message since I was > suggested to break down my questions posted > before. Please refer to V4 of CFAI text. > > 1. 2nd pargraph on P167 > …, many investors consider mortgages to be > “market-directional” investments … > > Can any one clarify the actual/clear meaning of > “market-directional” ? > > 2. P180 > > Why the Duration Hedge (refer to 1st table on 180) > is market-directional and the Two-Bond Hedge > (refer to 2nd table on 180) is not > market-directional ? How to judge ? > > Your help will be appreciated !
fixed income security prices move in the opposite direction of interest rates. so the market price changes are determined by the direction of change of interest rates. If rates move up prices fall , while if they move down prices rise. For treasuries ,prices rise at an ever increasing rate as rates fall and prices fall at an ever decreasing rate when rates fall. There is no optionality( only +ve convexity) A mortgage on the other hand has negative convexity when rates fall and positive convexity when rates rise . So the convexity is determined by the direction of rates i.e. it is a market directional security ( which just means it has optionality)
bell99 / janakisri : Thank you very much for your messages. It seems I got it. On P180, In 1st table : I/R up => Gain, I/R down => loss substantial (market-directional) In 2nd table : I/R both up & down => losses are small enough to be offset by the carry advantage of the MBS over treasuries. (not market-directional) By the way, refering to P180~181, do you know what was meant (implied) by the redution of the duration from 5.5 to 4.98 ? Thanks !
The hedge is better with the 2-bond than the duration hedge. For the investor , a hedge is supposed to preserve the value when rates increase . so a smaller duration is a better duration under the circumstances. ( remember duration measures the loss in value of the price of the security for a small move in rates ). A reduction of 9% in duration is a big advantage in times of rising rates. The duration hedge pays off better on the side of declining rates , when prepayments increase. But this advantage is small compared to the carry in the security ( i.e. the gain in the value of the security as rates fall ) The 2-bond loses a little more for declines but offsets the loss in principal better on the side of higher interest rates. In fact the duration change is almost nullified
janakisri, Thanks for your further response ! Can I conclude ? 2-bond hedge shall be used to hedge BOTH the NEGATIVE CONVEXITY and the TWIST of YC in a MBS, and the market-directionality of the MBS can be removed by the 2-bond hedge.
Does market directional mean dependent on interest rates?