MBS

MBS behaves like a bond with embedded call option.

It has negative convexity when interests are falling. 

And b/c of the embedded option like character, it can't be hedged using only Treasuries, or standard futures.

Five Risks Associated with Mortgage Securities

• Spread Risk
• Interest rate risk
• Prepayment risk
• Volatility risk
• Model risk

1. Spread Risk:

• **You do not want to hedge this risk**
• Buy more MBS when spread is wide and Sell when spread is narrow.

2. Interest Rate Risk:

• Usually hedged using Duration, however it isn't work very well.
• Increase Duration when interest expected to fall, and vice versa, 
• Duration only manage small changes in interest rate in a parallel movement, it doesn't capture the risk when there is yield curve twist or any other non-parallel movement. 
• Dynamic Hedging is the way to go.

3. Prepayment Risk:

• Can use Dynamic Hedge as well

4. Volatility Risk:

• B/c of the embedded call option, MBS generally more volatile than option free bonds
• The option can be hedged using options
• **As interest rate volatility increase the option value increases

5. Model Risk:

•  This is not really hedgeble risk. 
• More like human mistake