Mortgage Backed Securities (MBS) – What is Convexity Hedging?
From FT Alphaville:
…when interest rates are very low homeowners often take advantage of the rates by refinancing and paying down their old mortgages [prepayment speed increases]. When that happens, MBS owners find their bonds are repaid faster than expected. To offset that, the MBS investors usually buy longer-dated [longer maturity] assets such as Treasuries.
In the opposite scenario i.e.
When interest rates start to rise, the reverse occurs and MBS investors start selling longer-dated stuff
When rates rise borrowers, the speed of prepayment decreases and the average life of MBS extends beyond their original period… i.e. it takes longer for MBS holders to get their money back