Reading 30: Hedging Mortgage Securities to Capture Relativ mortgage, security, respect

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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 c: Contrast an individual mortgage security to a Treasury security with respect to the importance of yield curve risk.

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

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

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

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Answer and Explanation

A Treasury bonds 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.

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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.

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

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Answer and Explanation

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.

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When compared to a Treasury security, the key durations of a mortgage security are:

A) more in number and can only be positive while those of Treasury securities can be negative.

B) fewer in number and can only be positive while those of Treasury securities can be negative.

C) more in number and can be negative or positive while those of Treasury securities can only be positive.

D) fewer in number can be positive or negative while those of Treasury securities can only be positive.

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Answer and Explanation

A Treasury security with its bullet payment is likely to have only one and certainly fewer key durations than a mortgage security. The durations will have the usual positive sign. For interest only (IO) mortgage securities, some of the durations may be opposite to the normal sign, i.e., negative.