Credit Suisse First Boston looked at the various ways of computing hedge ratios that are open to investors in a recent report.
The list of possibilities enumerated by the bank includes using option-adjusted duration (OAD), using price spreads to come up with "market implied durations," determining empirical durations by using the most recent 20 business days (this is for short-term empirical durations) and by using 10-year passthrough price history, as well as using applied multipliers (which is derived from IO valuations). Analysts said that each method may have its own drawbacks but together they could provide an idea of how to hedge passthroughs and to identify relative value.
According to CSFB, the current degree of volatility in the market is particularly sticky due to the low-rate environment. This makes hedge ratios more difficult to determine.
OADs had been called the most maligned measure of mortgage risk. Analysts said that in an historically low-rate environment, the weakness of this measure is especially obvious. Models can actually generate many rate levels that have never been achieved previously. Thus, analysts noted, prepayment models tend to make CPR estimates for environments that are out-of-sample. Aside from this, systematic errors in prepayment models can make durations go too short when rates are high and too long when rates are low.
CSFB said that the best durations are given by utilizing passthrough prices over long periods of time. Not only do they make use of combined market wisdom, they also are not influenced by short-term excess widening and tightening. Applying short-term empirical durations is also advantageous because this method makes use of the markets' wisdom. However, this durations can be influenced by short-term spread widening and tightening.
The firm added that duration estimates implied by IO multipliers are handicapped by the fact that IOs and POs are required to have the same OASs, which is considered stringent. This method cannot be utilized for 15-year passthroughs or GNMAs, and they are also not a robust prepayment model fix.
Aside from this, analysts said that durations that are implied by price spreads have the disadvantage of being affected by the relative value of the coupon stack. CSFB gave the example that durations that are implied by price spreads on FN 6s and 7s are longer than current OADs. These are biased higher by the rich valuations on premiums, analysts noted.
