In a recent report, JPMorgan Securities studied the performance of dynamic hedging strategies to manage convexity risk in MBS portfolios. In the report, analysts examined the relationship between risk, returns and the frequency of dynamic hedging. They also examined the role of options in hedging convexity and vega risks. They said that looking at the difference between unhedged and hedged total returns effectively provides a synthetic asset total return index. Analysts also studied the historical performance of real and synthetric MBS, and made some conclusions about when synthetic assets are likely to outperform.
Analysts reiterated the importance of frequent dynamic duration hedging in MBS portfolios since this does a lot to minimize risk as well as to improve returns. Although the use of options in hedging convexity is useful in further reducing tail risk - over and above frequent duration hedging strategies - analysts said the improvement in absolute returns are more modest. By contrast, considering the lack of a carry benefit to offset vega risk, and the long-term mean reversion in implied volatility, analysts strongly urge the use of longer-dated swaptions in hedging vega risk in MBS portfolios.
"Vega risk, unlike being short convexity, provides offsetting carry -- vega hedging leads to significant improvements in risk-adjusted return," wrote analysts. "Investors concerned about potential extension in the mortgage market in the event of deleveraging of bank portfolios should switch into synthetic assets constructed by receiving in swaps and selling swaptions."
Analysts acknowledged that lower risk and better returns should also be weighed against increased transaction costs that are part and parcel of more frequent hedging. However, they concluded that the benefits derived from tighter delta rebalancing easily offset any increase in transaction costs, leading to improvements in risk-adjusted returns on MBS portfolios. Additionally, according to their analysis, utilizing a rule based on duration gap rather than one based on frequency would probably offer a good balance between improved risk returns on the one hand, and transaction costs on the other.
Lastly, they also introduced the JPMorgan hedged total return MBS indices, which analysts expect will greatly assist investors in evaluating their hedging approaches, and serve as a benchmark for the returns from synthetic MBS positions.
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