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

(4.) Dealers who attempt to hedge MBSs using offsetting Treasury positions are, by definition, using imperfect hedges. Because of the implicit path-dependent optionality and negative convexity of MBSs, hedges must be adjusted dynamically as market conditions change. See "Mortgage Security Structure: Call and Extension Risk

(5.) This process is probably somewhat symmetric. When interest rates fall, durations and maturities of MBSs shorten and MBSs are subject to call, or refinancing, risk (see "Mortgage Security Structure: Call and Extension Risk"). To hedge such call risk, market participants could sell shorter duration Treasuries and buy longer duration bonds, putting more downward pressure on long-term yields in the short run.

(6.) The slowing in prepayments exacerbates the effect that rising rates have on the price of the MBS because the repayment of mortgage principal occurs over a longer period.

(7.) In addition, some CMO tranches, by construction, contain substantially more extension risk than MBS pass-throughs and involve more complicated relationships between yield changes, prepayments, and duration than is suggested by Chart 3. For such securities, Chart 3 and the table on page 95 may underestimate changes in durations and thus changes in hedges.

(8.) We focus on dealer inventories of mortgage securities because they are the most likely to be dynamically hedged.

(9.) When the repo rate for a specific Treasury issue diverges from the repo rate for general collateral, it is said to be "on special" or "special."

(10.) On-the-run Treasuries provide the best liquidity for hedgers.

(11.) Because the last seven-year Treasury was issued in April 1993, the "seven-year Treasury" in Chart 6 is actually a six-year security during this period.

(12.) Open interest is the net number of outstanding futures contracts.

(13.) Increases in open interest suggest that market participants have established more permanent positions, and thus these increases may be interpreted as evidence of greater hedging activity within the futures market.

(14.) For the five- and ten-year futures, daily volume is one-third to one-half of open interest.