Reading 30: Hedging Mortgage Securities to Capture Relativ whether, discuss, mortgage, investing

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CFA Institute Area 8-11, 13: Asset Valuation
Session 9: Portfolio Management of Global Bonds and Fixed Income Derivatives
Reading 30: Hedging Mortgage Securities to Capture Relative Value
LOS b: Explain the risks associated with investing in mortgage securities and discuss whether these risks can be effectively hedged.

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All of the following are risks associated with mortgage securities EXCEPT:

A) model risk.

B) spread risk.

C) volatility risk.

D) beta risk.

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Answer and Explanation

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.

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

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

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

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

D) interest rate risk and spread risk are the same measure.

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Answer and Explanation

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.

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

A) does not change the securitys value relative to Treasuries.

B) decreases the securitys value relative to Treasuries.

C) increases the securitys value relative to Treasuries.

D) is an opportunity to short mortgage backed securities.

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Answer and Explanation

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.

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The effects of recent technological and institutional innovations on the market for mortgage-backed securities has increased:

A) volatility risk.

B) spread risk.

C) model risk.

D) beta risk.

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Answer and Explanation

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

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If a manager of mortgage backed securities is not hedging spread risk, the most likely reason is because hedging spread risk:

A) is impossible.

B) increases volatility risk.

C) reduces profitable opportunities.

D) is illegal.

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Answer and Explanation

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

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Negative convexity is more likely to become more severe if:

A) volatility decreases.

B) the spread increases.

C) volatility increases.

D) Treasury rates increase.

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Answer and Explanation

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.