Reading 30: Hedging Mortgage Securities to Capture Relativ

The best answer is go from negative to positive. As rates increase and the price declines, the prepayment option goes out of the money. We could also say the convexity, if already positive, can become more positive, but that was not one of the answers.

A declining market yield will cause the price to increase. This condition will make prepayment more likely, and make the convexity negative.

If the price is below par, the market yield must be higher than the yield on the underlying mortgages, and the prepayment rate will be lower. This means the instrument is more likely to exhibit positive convexity.

The most likely result is that the position with the hedge will decline because of the mortgage securitys negative convexity. As the yield decreases, the prepayment option goes in the money and the value of the security does not go up by as much as the value of the short futures position goes down because the futures position has positive convexity.

If the security is trading below par, then it is most likely to exhibit positive convexity, and this will make a hedge formed with a Treasury futures contract that has positive convexity more effective.

A hedge that is designed to be effective for changes of +/-50 basis points for a mortgage security trading at par will likely be less effective for decreases greater than 50 basis points. This is because of negative convexity. Since the mortgage security is likely to exhibit positive convexity for prices below par, the hedge is more likely to be effective for the larger increase in yield.

The fact that the price increase from the yield decline was less than the price decrease from the yield increase is indicative of negative convexity caused by a prepayment option.