R31 : various questions selling, following, statements, understand, reading

transferpricing

R31 (V4 of CFAI text)

I think that the main issue addressed in this reading is using two bonds to hedge
the MBS’s risks caused by both the parallel shift and twist (parallel shift) in the yield
curve instead of hedging the risks by “shorting Treasury securities” or “selling Treasury
futures”. However, I have following questions which confused me very much after my reviewing of this reading.

1. P166, last paragraph ~ P168.
I do not understand these statements. Specifically,
A. Does “Hedging a MBS’s I/R risk (the negative convexity when I/R decline) by either
“shorting Treasury securities” or “selling Treasury futures” mean “matching the
DOLLAR DURATION of the Treasury position with the DOLLAR DURATION of the MBS ?
B. What does “market-directional” actually mean ? (See also the 1st paragraph on
P180)
C. Is hedging a MBS’s I/R risk (the negative convexity when I/R decline) by either
“shorting Treasury securities” or “selling Treasury futures” the so-called “Duration
Hedge” on P179 ?

2. P179 ~ P181, under “b, Duration Hedge versus Two-Bond Hedge” on P179.
A. 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 ?
B. Is Two-Bond Hedge the only appropriate metod of hedging for MBS’s I/R risk (the negative convexity when I/R decline) ?
C. If I/R rise, what is the appropriate hedging for MBS’s I/R risk (for the cases of
that a MBS exhibits positive or negative convexity) ?

3. What is the yield (I/R) which will trigger the prepayment of a MBS (a I/R below
which the prepayment will start) ? Is it the coupon rate of the MBS ?

Anyone can help ?

mar350

My another question :
Duration Hedge = matching the DOLLAR DURATION of the Treasury position (“shorting Treasury securities” or “selling Treasury futures”, used to hedge) with the DOLLAR DURATION of the MBS ?

Windjam

Book 3 seems to be giving you fits today. Hopefully I can answer this q in a couple weeks when I get there.

canadiananalyst

I've got another question to throw into the mix:

On p172 under Volatility Risk it says:

"...The prepayment option granted to a homeowner is an interest rate option and therefore the homeowner’s prepayment option becomes more valuable when future interest rate volatility is expected to be high than when it is expected to be low. Because the OAS adjusts to compensate the investor for selling the prepayment option to the homeowner, OAS tends to widen when expected volatility increases and narrow when expected volatility declines."

I can understand that the total spread between the MBS and Treasury would change, but why would the OAS change?

According to their definition, the OAS is "the current spread over the benchmark yield MINUS that component of the spread that is attributable to any embedded optionality in the instrument".

So if the OAS supposedly nets out any value attributable to the option, why would it change when the option value changes?

nannan66

My further questions :
1. 2nd paragraph under “b, Duration Hedge versus Two-Bond Hedge” on P179.
... if the yield curve shift is a "level one"

What does it mean by "level one" here ?

2. 1st paragraph under "C. Prepayment Risk" on P171
... Termed negative convexity, this effect can be significant --- particularly for mortgage securities that concentrate prepayment risk such as "interest-only strips".

What does this mean ? Does this has to do with with the Exhibit 4/5 and those relevant statements on P170/171 ?'

3. 1st paragraph on P181
This implies that the two-bond hedge for the Fannie Mae 5% has a duration of 4.98. This is about 9% less than the duration of 5.5 for the Fannie Mae 5%.

What is the meaning (implication) of a two-bond "hedged" Fannie Mae 5% with a duration of 4.98 versus its original duration of 5.5 ?

4. The question posted by cfacareerchanger (as above)

Sorry, I have so many questions but any advice will be much appreciated.