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.