Even with the recent disappointing employment report and the subsequent rate rally, the convexity needs of the mortgage sector have been rather muted, analysts said. UBS said that this could be attributed to market participants adding positive convexity via the swaptions market at attractive levels over the previous weeks.
However, analysts said that if the market rallies further, the convexity hedging needs of all market participants becomes more magnified. The needs of both originators and servicers rise as the average dollar price in the MBS market goes from 101 to the 102.5-dollar price range. They also noted that the convexity hedging needs from originators increase in line with refinancings. Furthermore, analysts do not think servicers added sufficient optional coverage protection against a major rally.
Similarly, Lehman Brothers indicated in a report last week that convexity hedging will only be a concern should the market rally further. Also, they do not believe that convexity hedging should cause a considerable spike in implied volatility. The GSEs' stagnant portfolio growth implies much lower convexity hedging needs from them, which represents a big part of the mortgage market. However, despite the absence of the GSEs, mortgage servicers still provide a source of convexity hedging. Lehman researchers added that although servicing portfolios are not very convex, approximately 50% of duration exposure is hedged via mortgages..
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