A depository institution holds IO strips as a hedge against its regular bond portfolio. The CFO argues this hedge will be effective, but the risk manager expresses concern. Under what market scenario would the IO hedge fail to provide the expected protection?

Question

BlackTom AI · Accepted Answer

The question asks under what market scenario an IO strip hedge would fail to provide the expected protection for a bank’s bond portfolio.
Option (the only provided choice): When rates rise significantly above the mortgage pool's coupon rate, the IO strip begins behaving like a regular bond with positive duration, causing both IOs and the regular bond portfolio to decline together as rates rise.
First, consider the basic mechanics: IO strips (interest-only on a mortgage-backed security) have value that is highly sensitive to the level and path of interest rates. When rates rise, prepayment speeds tend to fall, which can affect the cash flows to IOs differently than to principal-only or regular bonds. As rates rise enough that the IO behaves more like a standard fixed-rate instrument with duration, its price moves in a way that is similar to a regular bond.
Next, analyze why this would be a hedging failure: the purpose of an IO hedge is typically to offset losses in a regular bond portfolio when rates move. If the IOs start to behave like regular bonds with positive duration, their prices will fall in parallel with the regular bond portfolio when rates rise. Instead of providing a diversifying or offsetting effect, the hedge loses its distinct, opposing sensitivity and may even exacerbate losses if both the hedge and the portfolio move downward together.
Additionally, the reliance on a mortgage pool coupon rate being significantly below market rates is crucial. If rates rise well above that coupon, the discrepancy causes the IO’s duration exposure to resemble that of the underlying bonds, aligning their price movements with the portfolio rather than counteracting them. In such a scenario, the intended hedging benefit vanishes because the two exposures no longer have the expected negative correlation.
In summary, the scenario described—rates rising substantially above the mortgage pool’s coupon rate causing the IO strip to act like a positive-duration instrument—fits the idea of the hedge failing because both components would decline in value as rates go up, undermining protection rather than delivering it.

BU.231.710.51.FA25 PoP Quiz - 3 (Week 6)

A depository institution holds IO strips as a hedge against its regular bond portfolio. The CFO argues this hedge will be effective, but the risk manager expresses concern. Under what market scenario would the IO hedge fail to provide the expected protection?

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