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MIS 4500 (31)

Chapter 31.docx

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University of Manitoba
Management Info. Systems
MIS 4500
Pourang Irani

Chapter 31: Hedging Mortgage Securities to Capture Relative Value Convexity  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 Mortgage Security Risks:  1. Spread risk: o portfolio manager does not seek to hedge spread risk, but increases allocation to mortgage securities when yield spreads are wide and reduces when narrow  2. Interest Rate Risk: corresponds to interest rate risk of comparable Treasury securities; can be hedged directly by selling Treasury notes or Treasury note futures o yield curve risk: exposure to nonparallel change in yield curve shape  rate duration: can provide some measure of exposure  key rate duration: rate duration for key maturities  can model steepening  POs have high positive duration; IOs have high negative duration  3. Prepayment Risk: o w/ prepayment option, duration of mortgage securities extends as rates rise and shortens as rates fall  the percentage increase in price becomes smaller and smaller as rates decline; percentage decline in price becomes greater and greater as interest rates rise. o hedge by hedging dynamically or buying options  4. Volatility Risk: option value increases w/ interest rate volatility o hedge by hedging dynamically (when high volatility expected to normalize) or buying options (when low volatility and expect to increase)  5. Model Risk: current models calibrate to historical experience; consider prepayment innovation o cannot hedge, but can measure How Interest Rates Change Over Time:  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 Hedging Methodology:  Interest Rate Sensitivity Measure: Richard and Gord’s Interest Sensitivity (IRS): measures % price change in response to shift in yield curve o two bon
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