I thought both a call option and an MBS would decrease convexity, since the MBS could be prepaid and the option can be called away? Why would a near-the-money call option on Treasury bond futures add convexity?
Text - "In exchange for a higher yield at the outset, the owner of the callable bond has effectively sold a call option to the issuer of the bond. He owns all of the downside but risks having the bond called away from him if yields fall (and prices rise) beyond the call price. This price behavior is often referred to as “negative convexity.”
Question:
Based on Zhao’s forecast of an instantaneous parallel downward shift in the yield curve, she also considers selling a portion of the US Treasury securities in her portfolio and buying one of the following two investments:
| Investment 1 | A mortgage-backed security (MBS) |
|---|---|
| Investment 2 | A near-the-money call option on 20-year Treasury bond futures |
The effective duration of the resulting portfolio will be closely matched to Zhao’s current portfolio.
Justification:
- Investment 2 is the most appropriate investment choice given Zhao’s yield curve forecast.
- Purchasing a near-the-money call option on Treasury bond futures would add convexity and better position the portfolio for the forecasted downward parallel shift in the yield curve.
- Buying an MBS would decrease convexity, which would not be ideal given Zhao’s expectation of a downward parallel shift in the yield curve.
In the case of an instantaneous downward parallel shift in the yield curve, a portfolio with added convexity resulting from the purchase of a near-the-money option on Treasury bond futures would increase in value more than a portfolio without the call option. Purchasing an MBS would decrease convexity, which would not be ideal given Zhao’s expectation of an instantaneous downward parallel shift in the yield curve.
There would be no significant effect on the portfolio resulting from duration because the durations are closely matched.