burning0spear

For a mortgage security trading at par and a hedge formed with a short position in a Treasury futures position that is designed to maintain a stable value, the hedge would still be effective if:

A) there is a 100 basis point decrease in yield.

B) there is a 100 basis point increase in yield.

C) there is a 75 basis point decrease in yield.

---

A hedge that is designed to be effective for changes of +/-50 basis points for a mortgage security trading at par will likely be less effective for decreases greater than 50 basis points. This is because of negative convexity. Since the mortgage security is likely to exhibit positive convexity for prices below par, the hedge is more likely to be effective for the larger increase in yield.

burning0spear

For a mortgage backed security trading at par, a large increase in market rates is most likely to make the security’s convexity:

A) become infinite.

B) go from positive to negative.

C) go from negative to positive.

---

The best answer is go from negative to positive. As rates increase and the price declines, the prepayment option goes out of the money. We could also say the convexity, if already positive, can become more positive, but that was not one of the answers.

burning0spear

A mortgage security’s convexity is most likely to become negative if the market yield is:

A) increasing and the price moves below par.

B) declining and the price moves above par.

C) declining and the price moves below par.

---

A declining market yield will cause the price to increase. This condition will make prepayment more likely, and make the convexity negative.