burning0spear

Negative convexity is more likely to become more severe if:

A) volatility decreases.

B) volatility increases.

C) the spread increases.

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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 security’s convexity more positive.

burning0spear

An increase in the credit spread of a mortgage backed security:

A) increases the security’s value relative to Treasuries.

B) does not change the security’s value relative to Treasuries.

C) decreases the security’s value relative to Treasuries.

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

burning0spear

In analyzing the risk of mortgage backed securities, we say that:

A) interest rate risk is a component of spread risk.

B) interest rate risk and spread risk are distinct measures.

C) spread risk is a component of interest rate risk.

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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.

burning0spear

When comparing the number of key rates needed in hedging a mortgage security versus a Treasury security, we generally need to consider:

A) more key rates for the mortgage security because of its bullet payment at maturity.

B) more key rates for the mortgage security because it lacks a bullet payment at maturity.

C) fewer key rates for the mortgage security because it lacks a bullet payment at maturity.

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A Treasury bond’s price is affected most by changes in the yield associated with its maturity, and this is because of the large bullet payment for that type of bond. Because a mortgage security is essentially an annuity, changes of other rates become more important.

burning0spear

When compared to a Treasury security, the yield curve risk of a mortgage security is generally:

A) more important and decreases in importance for non-parallel shifts of the yield curve.

B) less important and increases in importance for non-parallel shifts of the yield curve.

C) more important and increases in importance for non-parallel shifts of the yield curve.

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Because of the prepayment option and the fact that there is not a bullet payment option at maturity, mortgage securities have more yield curve risk, which is by definition caused by non-parallel shifts of the yield curve.

burning0spear

A duration-based framework for hedging a mortgage security may lead to be a greater loss than not hedging if the price of the mortgage security is:

A) below par.

B) at all values.

C) above par.

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When the price is above par, negative convexity is more likely to be a problem. If the market yield declines, the hedge will decline in value while the price of the mortgage security may not increase. This will lead to a greater loss than if the security were not hedged at all.

burning0spear

Using only a duration-based framework for hedging a mortgage security is most appropriate if the price is:

A) above par and the expectation is a parallel shift of the yield curve.

B) below par and the expectation is for a parallel shift of the yield curve.

C) above par and the expectation is for a non-parallel shift of the yield curve.

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For all types of securities, duration-based strategies are most effective for parallel shifts of the yield curve. If the price is below par for a mortgage security, then the price is more likely to exhibit positive convexity, and a duration-based hedge will be more effective.

burning0spear

Using only a duration-based framework for hedging is:

A) more appropriate for a mortgage security than it is a Treasury security.

B) more appropriate for a Treasury security than a mortgage security.

C) equally important for both mortgage and Treasury securities.

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Duration-based techniques are more important for Treasury securities with positive convexity. The negative convexity of mortgage securities makes duration a less meaningful measure in hedging them.

burning0spear

A given mortgage security is trading at par. The expected average price change from a projected change in a given market yield is 1 for the mortgage security and 0.4 and 2.0 for hedging instrument one and two respectively. The expected average price change from a projected twist in the yield curve is 0.4 for the mortgage security and 0.3 and 0.5 for hedging instrument one and two respectively. What positions in hedging instruments one and two should a manager take to hedge the price of the mortgage security from the projected market changes? For every dollar of face value of the mortgage security:

A) buy $2.5 of hedging instrument one and $0.5 of hedging instrument two.

B) sell $0.75 of hedging instrument one and $0.35 of hedging instrument two.

C) sell $2.5 of hedging instrument one and $0.5 of hedging instrument two.

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To answer this, we set up the following two equations and two unknowns.(NH1)(0.4) + (NH2)(2.0) = -1.0
(NH1)(0.3) + (NH2)(0.5) = -0.4,
where NH1 and NH2 are the positions to take in hedging instruments one and two respectively. Multiplying the second equation by 4 and subtracting it from the first gives (NH1)(-0.8)=0.6, and thus NH1=-0.75. Substituting this into either expression and solving NH2 gives NH2=-0.35.(-0.75)(0.4)+(-0.35)(2)=-1
(-0.75)(0.3)+(-0.35)(0.5)=-0.4

burning0spear

When a one-bond hedge is inadequate for hedging a mortgage security and a two-bond hedge is required, all of the following are necessary assumptions for using a two-bond hedge EXCEPT:

A) reliable assumptions in the Monte Carlo simulations of interest rates.

B) the yield curve will shift in a parallel fashion.

C) the security’s price change given a small change in yield.

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A usual reason a two-bond hedge is required is that the yield curve is expected to shift in a non-parallel fashion.