MBS Hedge question, sufficient, several, best, test

AnalystForum

If on test day there is a question that states why does a 2 bond hedge work for an MBS..do you think the below answer would be sufficient/give me full points?

- In non-callable bonds a single key rate change causes most of the change in price.
- In callable bonds with not bullet at end, they are vulnerable to change in several key rates.
- As majority of change in price is due to yield curve shifts and twists, a 2 bond hedge from two maturity sectors of the yield curve would works best.

Roflnadal

I think they'd be looking for info that you understand MBS has both areas of negative and positive convexity and what that means in order to hedge with treasury securities for twists.

IAmNeil

I'd add to Sponge Bob's comments that a Duration hedge only hedges a parallel shift in the yield curve, and as your statement #3 states a 2 bond hedge hedges both the shift and the twist.

Also, the text points out that even though the hedge positions may lose a little money, the yield advantage of the long position in the underlying MBS (over the Treasuries shorted in the hedge) more than compensates for a slight loss on the hedge.