New Strategy for Dynamically Hedging Mortgage-Backed Securities
JOURNAL OF DERIVATIVES, Vol 2 No 4
Posted: 25 May 1998
This article develops a new approach for hedging mortgage- backed securities (MBS) that involves estimating the joint distribution returns on MBS and T-note futures, conditional on economic conditions. The resulting hedge ratio is calculated by differentially weighting past pairs of MBS and T-note futures returns, where the weights depend on how close current economic variables are to their historical values.In an out-of-sample hedging exercise, using weekly and monthly returns on 8%, 9%, and 10% GNMAs over the 1990-1994 period, the dynamic approach is very successful at hedging out interest rate risk. For example, in hedging weekly returns on 10% GNMAs, the method reduces the volatility of the return from 4.1 to 2.4 basis points, while a static method achieves only 29 basis points of residual volatility. Moreover, only 1 basis point of the volatility of the dynamically hedged return can be attributed to risk associated with U.S. Treasuries, compared to 14 basis points of interest rate risk in the statically hedged return.
JEL Classification: G12, G13, G21
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