The authors evaluate the benefits of a three-factor hedging strategy relative to a one-factor and a two-factor strategy when using mortgage pass-through securities. Using principal component analysis, each factor corresponds to the components of the yield curve: level, slope, and curvature. An effective hedging strategy inclusive of these dynamics should result in returns equivalent to the risk-free rate.
What Is the Investment Issue?
The authors theorize that an effectively hedged mortgage pass-through should return the risk-free rate over the time horizon, and they expand on prior research related to one-factor and two-factor models.
How Did the Authors Conduct This Research?
The authors rely on principal component analysis (PCA). The principal components are constructed so that (1) the first principal component accounts for as much of the variability in the data as can be explained by a single variable and (2) each succeeding principal component explains the maximum variance possible under the condition that it cannot be correlated with any of the previous principal components.
The authors used monthly interest rate changes over a six-year period: 4 January 2010–31 December 2015; terms of one, three, and six months and 1, 2, 3, 5, 7, 10, and 30 years are used. The remaining points are determined via interpolation. Interpolation between the observed yields and tenors is performed using a polynomial basis spline. They use the following contracts for the analysis: March (H) 2015, June (M) 2015, September (U) 2015, December (Z) 2015, and March (H) 2016 contracts. Bond Lab is used to calculate the price change of the mortgage pass-throughs. All pricing data used to test the performance of each of the three hedging strategies are from Bloomberg Financial Markets. Treasury note and bond monthly returns and price changes are calculated using Bond Lab’s BondScenario function.
What Are the Findings and Implications for Investors and Investment Professionals?
The ability of the three-factor hedging strategy to capture changes in the curvature of the term structure leads to superior hedge performance by improving the ability to hedge the negative convexity of mortgage pass-through securities. If a mortgage pass-through security could be hedged so that the value is not affected by changes in the yield curve, then the marginal return offered by these securities could be captured. The ability for dealing desks to hedge mortgage pass-through positions is critical for firm risk management.
Market participants should have risk management tools readily available to manage and hedge risks as needed. Because mortgage pass-through products can be challenging to hedge, the authors document and demonstrate hedging strategies that can be used to address the risk exposures to the level, slope, and curvature of the yield curve. This knowledge will provide practitioners with effective tools to manage more sophisticated products—for example, mortgage pass-through products. The authors also demonstrate that although less sophisticated approaches to hedging mortgage pass-through products are effective in certain interest rate environments, they may not be suitable for all interest rate environments, such as when negative convexity dramatically impacts pricing. Similarly, it is critical for market participants to fully understand the advantages and limitations of each respective approach to risk management.
The authors’ research provides valuable insight into risk management approaches and tools available to manage the interest rate risk associated with mortgage pass-through products. The mortgage industry has evolved considerably over recent years, and as a result, risk management tools need to be constantly evaluated for effectiveness. I would enjoy seeing further research regarding alternative, less liquid risk management strategies and how these compare with the strategies outlined in this research.