Hedging: Convexity Hedging Requires Attention to Duration Management.(Brief Article)

Interest rates are the central focus of hedging strategies. But hedging a mortgage portfolio, for an investor or a servicer, requires close attention to how rates affect the duration of the asset. But today, some of the tools that lenders are using to estimate mortgage duration are flawed, according to analysts at UBS Warburg.

"It has always been one of our longstanding views that OAS models can be quite misleading about the duration," said Jeffrey Ho of UBS Warburg.

An implicit assumption underlying most of the option-adjusted spread models is that the spreads relating to swap instruments used in hedging remain unchanged as rates rise and fall. But historically the spreads do in fact change, he said.

Therefore, UBS Warburg believes that people trying to hedge the convexity out of their portfolio should rely on empirical evidence about how hedge durations have behaved in the past to get a feel for what will happen this time around.

Mr. Ho says it is appropriate to use OAS models, as long as you understand and account for their limitations in measuring duration.

When the bond markets rally, lenders lose duration on their mortgage portfolio. According to USB Warburg's Market Strategist newsletter, they often turn to swaps in order to make up the duration they lose as their market rallies.

But "convexity" hedgers face a problem as the market sells off. Investors and servicers may need to shed this extra duration as the mortgage market lengthens. UBS Warburg warned lenders and mortgage ...