MIS 4500 Lecture Notes - Fixed-Income Attribution, Principal Component Analysis, Interest Rate Risk

• School: University of Manitoba
• Department: Management Info. Systems
• Course: MIS 4500
• Professor: Pourang Irani

Document Summary

Chapter 31: hedging mortgage securities to capture relative value. Value of mortgage security = value of treasury security value of prepayment option. Many investors consider mortgages to be market-directional investments that should be avoided when interest rates expected to decline. Spread risk: portfolio manager does not seek to hedge spread risk, but increases allocation to mortgage securities when yield spreads are wide and reduces when narrow. Key rate duration: rate duration for key maturities. Pos have high positive duration; ios have high negative duration. Volatility risk: option value increases w/ interest rate volatility: hedge by hedging dynamically (when high volatility expected to normalize) or buying options (when low volatility and expect to increase) Model risk: current models calibrate to historical experience; consider prepayment innovation: cannot hedge, but can measure. Statistical technique used to decompose rate movements: principal components analysis. 95% of historical movements in rate changes explained by 1. overall level of interest rates and 2. twists in yield curve.