Mortgage security hedging and the yield curve - includes article about call and extension risk

Federal Reserve Bank of New York - Quarterly Review, Summer-Fall, 1994 by Julia D. Fernald, Frank Keane, Patricia C. Mosser

Just as dealers may use Treasury securities to hedge their MBS positions, portfolio managers who hold mortgage securities often use the government securities market to adjust their portfolios in an attempt to maintain a target duration. From a market dynamics standpoint, such portfolio rebalancing is analogous to dealer hedging of mortgage inventories: as interest rates rise and mortgage securities extend, the portfolio's duration increases. Longer duration in turn prompts managers to sell longer maturity Treasuries to regain their portfolio's target duration. If many portfolio managers attempt such duration adjustments simultaneously, the excess supply of longer maturity Treasuries will steepen the yield curve.

Mortgage Prepayments and the Shift in Monetary Policy

Although long rates began rising in late 1993, MBS dealers were slow to lower their forecasts of MBS prepayment rates (see table below). After the change in policy direction in February, however, estimates of expected future prepayment rates dropped sharply, presumably because the policy change signaled that further declines in interest rates were unlikely. In fact, in 1992 and 1993, mortgage prepayment rates had been much higher than most dealers had anticipated, and so the policy shift may have caused a particularly large drop in assumed prepayment speeds.

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Chart 3 illustrates how critical prepayment expectations are for mortgage security prices and durations. In the chart, we consider the relationships among price, yield, and prepayment speed for an 8 percent coupon thirty-year conventional MBS currently yielding 9 1/2 percent at a prepayment speed of 15 percent (point A). As interest rates change, different assumptions about prepayment response to the change in yield determine both the price and the duration of an MBS. For example, a 50 basis point increase in yield that does not affect the speed of mortgage prepayments would lead to a move from point A to point B and a price decline of 1.92 percent. More realistically, the increase in rates could slow prepayments from 15 percent to 10 percent per year--a move from point A to point C--and cause a larger 3.75 percent price decline. Alternatively, a fundamental change in the direction of future rates could produce a large drop in prepayments to, say, 5 percent per year--a move from point A to point D--and a large drop in the MBS price.(6)

With slower prepayments, the duration of the MBS is longer as well. In Chart 3, the duration of the MBS depends on the slope of the line connecting point A to one of the three other points--whichever reflects the expected prepayment speed. The effect of prepayment assumptions on duration is sizable, even for relatively small interest rate changes. A 50 basis point increase in rates with no change in prepayments (point B) will give this MBS a duration of 3.28, or approximately that of a four-year Treasury. If the same 50 basis point increase in rates is accompanied by a drop in prepayment speed from 15 percent to 5 percent (point D), duration increases to 5.36, roughly that of a seven-year Treasury.