Reading 30: Hedging Mortgage Securities to Capture Relativ

Beta is not generally a concept directly associated with mortgage securities. Model risk is important because the current value depends upon patterns of interest rates and prepayment rates. The changing spread can influence the assets value. Because of the embedded option, volatility risk is important too.

Interest rate risk is associated with the risk from movements in Treasury securities. Spread risk is a separate component associated with the credit properties of the security as well as macroeconomic factors.

An increase in the spread means the yield of the mortgage backed security has increased relative to Treasuries so the securitys value has decreased relative to Treasuries. This would be an opportunity to buy mortgage backed securities.

The innovations have had a direct effect on the ability of models to predict prepayment rates.

A manager can earn profits by buying mortgage backed securities when the spread widens and selling when the spread narrows.

Negative convexity can be interpreted as the negative effect on price caused by an increase in the value of the embedded, short call option in the mortgage security. An increase in volatility will increase the value of that option and increase the severity of the negative convexity. An increase in the spread and/or Treasury rate will likely increase the yield of the mortgage security, and this will tend to make the securitys convexity more positive.