A New Strategy for Dynamically Hedging Mortgage-Backed Securities

Posted: 28 Apr 1998

See all articles by Jacob Boudoukh

Jacob Boudoukh

Reichman University - Interdisciplinary Center (IDC) Herzliyah

Matthew P. Richardson

Department of Finance, Leonard N. Stern School of Business, New York University

Richard Stanton

University of California, Berkeley - Haas School of Business

Robert Whitelaw

New York University; National Bureau of Economic Research (NBER)

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Abstract

This paper develops a new strategy for dynamically hedging interest-rate contingent claims, such as mortgage-backed securities (MBSs). The approach involves estimating the joint distribution of returns on MBSs and T-note futures, conditional on current economic conditions. We show that our approach has a simple intuitive interpretation of forming a hedge ratio by differentially weighting past pairs of MBS and T-note futures returns. As an example, an out-of-sample hedging exercise is performed for 8%, 9% and 10% GNMAs over the 1990-1994 period for weekly and monthly return horizons. The dynamic approach is very successful at hedging out the interest rate risk inherent in all of the GNMAs. In hedging weekly returns on 10% GNMAs, our dynamic method reduces the volatility of the GNMA return from 41 to 24 basis points, whereas a static method manages 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, which is in contrast to 14 basis points of interest rate risk in the statically hedged return.

JEL Classification: G12, G13, G21

Suggested Citation

Boudoukh, Jacob and Richardson, Matthew P. and Stanton, Richard H. and Whitelaw, Robert F., A New Strategy for Dynamically Hedging Mortgage-Backed Securities. Available at SSRN: https://ssrn.com/abstract=6166

Jacob Boudoukh (Contact Author)

Reichman University - Interdisciplinary Center (IDC) Herzliyah ( email )

P.O. Box 167
Herzliya, 4610101
Israel

Matthew P. Richardson

Department of Finance, Leonard N. Stern School of Business, New York University ( email )

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Richard H. Stanton

University of California, Berkeley - Haas School of Business ( email )

Haas School of Business
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Berkeley, CA 94720-1900
United States
(510) 642-7382 (Phone)
(510) 643-1412 (Fax)

Robert F. Whitelaw

New York University ( email )

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States
212-998-0338 (Phone)
212-995-4233 (Fax)

National Bureau of Economic Research (NBER)

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Cambridge, MA 02138
United States

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