A New Strategy for Dynamically Hedging Mortgage-Backed Securities

This paper develops a new strategy for dynamically hedging 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. 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. For example, 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