Reading 32: Hedging Mortgage Securities to Capture Relati

Investment, mortgage, contrast, increase, interest

LOS d: Compare and contrast duration-based approaches versus interest rate sensitivity approaches to hedging mortgage securities.

Q1. James Prescott is a portfolio manager with Atlantic Investment Management Company. Prescott forecasts that interest rates will remain at their current level, however he expects that their volatility will decline. As a result, he is adjusting a fixed-income portfolio. The goal is to increase the return of the portfolio while managing the risk appropriately. The current portfolio consists of $80 million long-term Treasury bonds and $60 million short-term Treasury bonds. Given his interest-rate forecast of stable rates with low volatility, he uses a parallel yield curve shift of 20 basis points to compute the bonds’ dollar durations. For a 20 basis point change, the dollar duration of the long-term bonds is $1.2 million and the dollar duration of the short-term bonds is $0.5 million. Before adjusting the portfolio, Prescott fully hedges the portfolio for the potential 20 basis point shift with futures contracts that have the same maturity as the short-term and long-term position and in the same relative amounts.
Prescott is considering two possible choices to increase the return of the portfolio.

Choice A would convert half of the short-term bonds to long-term bonds.
Choice B would convert half of both positions to mortgage backed securities with maturities equal to each of the previous positions.

The mortgage-backed securities are trading at a discount from par and offer a 70 basis point spread over the long-term Treasury securities. Prescott determines that for the forecasted yield curve shift, a duration-based strategy is appropriate.
Prescott decides on choice B. He decides to keep the same position in Treasury futures as a hedge. Shortly thereafter, there is a 40 basis point increase in short-term rates and a 60 basis point increase in long-term rates. The hedge proves to be ineffective.

For a 20 basis point shift, what was the dollar duration of the original bond portfolio without the hedge?

A) $2.40 million.

B) $1.70 million.

C) $1.50 million.

Q2. If Prescott had chosen Choice A and had not changed the hedge, the dollar duration of the entire position including the futures would most likely have:

A) decreased.

B) increased.

C) been unaffected.

Q3. Which of the following would be most appropriate to improve the hedge for Choice B? Purchasing:

A) puts on Treasury futures to hedge against large interest rate increases.

B) calls on Treasury futures to hedge against large interest rate decreases.

C) puts on Treasury futures to hedge against large interest rate decreases.

Q4. All of the following support Prescott’s assessment that a duration-based hedge of the mortgage securities would be adequate EXCEPT:

A) the forecast of a low volatility of rates.

B) he replaced the Treasury securities with equal amounts of mortgage securities of the same maturity.

C) the mortgage securities were trading below par.

Q5. Reasons for the hedge proving ineffective include all of the following EXCEPT:

A) the interest rate changes were more than 20 basis points.

B) the negative convexity of the mortgage securities.

C) only two key rates were used in the hedge.

Q6. For this question only, suppose now that the Treasury yield curve had not shifted. Instead, the spread of the mortgage securities increases while the Treasury rates do not change. If the same hedge is in place, then the value of the:

A) hedged portfolio would decline.

B) hedged portfolio would increase.

C) hedged portfolio would remain the same.

Q7. 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.

Q8. Using only a duration-based framework for hedging a mortgage security is most appropriate if the price is:

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

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

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

Q9. 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.

. simple question- FRA