Hedging Dynamically

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Hedging dynamically requires that we buy futures after rates have declined (makes sence) and shorten duration by selling futures after rates have increased.
This does not make sence. If the rates increase, MBSs are in the positive convexity region (according to the graph on page 164 of R 26), and we still have to sell futures to shorten it further?
Or does “hedging dynamically” assume we only have negative convexity?
 
Dynamic hedge usually keeps duration = 0. You may or may not hedge convexity.
Hedge duration with swap, treasury futures. Some loans can also offset part of duration.
Convexity could be hedged with treasury options, I think.
 
I dont think this is the correct way to put it. If i reduce my duration to 0, i will have no incentive to keep a security - because the price of the security would not react to movements in interest rates.
The book wants us to increase the duration, when interest rates fall, i.e. to “boost” the upswing. And to reduce the duration when interest rates increase i.e. to “apply brakes” when there is already “natural” braking going (due to positive convexity). This part i dont understand…
 
With MBS the manager attempts to earn the spread . Rate increases and decreases are not where the alpha is earned. So you hedge out the curves,twists,level shifts etc. and earn the spread , which is really due to the OAS
 
Hedging dynamically may mean this :
Prepayment risk - now what I understood is when int rate increase, prepayment period extends (i.e. like in a floating mortgage loan - if interest rate increases & you don’t wish to change ur monthly mortagage cost (EMI) your tenor increases in amortization schedule). When interest rate decreases, prepayment period shortens.
This means that mortgage duration is increasing (i guess due to increase in prepayment period) when interest rate increases & mortgage duration decreases when int rate decreases. This is against our desire. I mean we would like duration to increase when int rate goes down (to make it more sensitive to int rate to capture larger gains) & duration to decrease when int rate goes up (to loose less). To hedge we need to buy options or hedge dynamically. Hedging dynamically will require us to to increase duration (buy futures) when rates decline & decrease duration (selling futures when int rate increase. )
 
duration is the key point when considering hedging
For a security(MBS) with negative convexity, the duration changes in an opposite direction with regard to to the interest rates change.“Hedging dynamically” applies only in the regime where MBS shows negative convexity.
 
duration is the key point when considering hedging
For a security(MBS) with negative convexity, the duration changes in an opposite direction with regard to to the interest rates change.“Hedging dynamically” applies only in the regime where MBS shows negative convexity.
 
I am not very sure about what I posted above.
Pls see the table on page 166 of R 26.I speculated my point of view from this table.
Pls correct me if I had somewhere wrong.
 
I am not very sure about what I posted above.
Pls see the table on page 166 of R 26.I speculated my point of view from this table.
Pls correct me if I had somewhere wrong.
 
Thanks, ultrablue. That’s the table to mark for review.
That table tells a little different story. When the convexity is negative: the duration and the rate move in the same direction.
 
ultrablue wrote:
duration is the key point when considering hedging
For a security(MBS) with negative convexity, the duration changes in an opposite direction with regard to to the interest rates change.“Hedging dynamically” applies only in the regime where MBS shows negative convexity.
Click to expand...
This would answer my question, but unfortunately, there is nothing in the book which explicitly says that…
 
I am sorry, i dont understand why dynamic hedging is confined to the negative convexity region of a MBS. Surely, the logic of managing durations is equally valid in a positive convexity region ?
[1]negative convexity region
  • interest decline -> duration of MBS declines -> long futures to hedge
  • interest rise -> duration of MBS rises -> short futures to hedge
[2]positive convexity region
  • interest decline ->duration of MBS rises ->short futures to hedge
  • interest rise -> duration of MBS falls -> long futures to hedge
ty
 
Alladin wrote:
[2]positive convexity region
  • interest decline ->duration of MBS rises ->short futures to hedge
  • interest rise -> duration of MBS falls -> long futures to hedge
ty
Click to expand...
in +ve convexity region
  • interest decline - duration of MBS rises. If int rates are decreasing you would like to make ur security/portfolio more sensitive to int rate due to its opposite effect on price. If duration is rising in this case then you are capturing more prise rise. Why would you short the futures to decrease your duration if int rate are expected to decrease.
  • Likewise, if int rate are rising & duration of MBS is falling so it will fall less. Its a good thing & at par with your general wish to reduce int rate sensitivity of your security/portfolio when int rate are expected to rise. You won’t take a long position in futures to create more downfall.
 
rahuls wrote:
Alladin wrote:
[2]positive convexity region
  • interest decline ->duration of MBS rises ->short futures to hedge
  • interest rise -> duration of MBS falls -> long futures to hedge
ty
Click to expand...
in +ve convexity region
  • interest decline - duration of MBS rises. If int rates are decreasing you would like to make ur security/portfolio more sensitive to int rate due to its opposite effect on price. If duration is rising in this case then you are capturing more prise rise. Why would you short the futures to decrease your duration if int rate are expected to decrease.
  • Likewise, if int rate are rising & duration of MBS is falling so it will fall less. Its a good thing & at par with your general wish to reduce int rate sensitivity of your security/portfolio when int rate are expected to rise. You won’t take a long position in futures to create more downfall.
Click to expand...
thx rahuls,
i understand that positive convexity is desirable from an investors perspective, but if the purpose of hedging is to offset movements rather than to capture gains shouldnt the logic apply to both negative/positive convexity regions, even if offsetting in positive convexity regions is counterproductive??…hehe i L2 i would have simply assumed that hedging against +convexity is meaningless…but in L3 i m a bit more cautious…dunno why
 
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