Event Driven Hedge Funds

“a

Event Driven Strategies• Bankruptcy (in and out of…)

– High Yield/Distressed– Credit Swaps

• Corporate reorganization; restructuring• Fundamental change in business environment;

competition• Lawsuits; legislation• M&A• Structured Bonds (Mortgage Backed Securities)

High Yield/Distressed Debt Investing

Fixed Income Markets and Funds

Fixed Income Strategies• Relative Value

– Long debt of one company and short debt of another in same industry; US and International• Capital Structure Arbitrage

– Long municipal debt, short corporate debt– Long senior debt, short subordinated– Long high yield, short equity– Long 1 year short 10 year of same company

• Event Driven– Relies on catalyst to release value

• M&A arbitrage• Bankruptcy or exit from bankruptcy• Corporate restructuring, exchange offers, recapitalization, asset sales, debt buyback• Ratings trigger downgrading from investment to high yield

• Credit/Distressed– Relies on mispricing of security risk

• High yield• Corporate credit arbitrage• Distressed securities (debt and equity)

• Directional Long/Short– Long

• Safer end of distressed (between high yield and distressed)• Secured Financing• Loan syndicated debt

– Short negative credit view of industry of issuer

Spectrum of Fixed Income Investing

Asset Backed SecuritiesEquipmentCommercialFuture FlowConsumerSpecial SituationsDirect Portfolio LendingMezzanine LendingDistressedDerivatives

CDO’sMiddle MarketLoansHigh Yield BondsReal EstateABSCDOHigh Grade

Commercial Real EstateLarge LoansSubordinated ClassesDirect LendingSpecial SituationsMezzanine Lending

Credit DerivativesCorrelation TradingCredit Default SwapsBaskets Indices

Leveraged CreditLeveraged LoansDistressedMezzanine DebtSpecial SituationsDirect PlacementHigh Yield BondsConvertiblesPIPESETC’sDerivatives

Residential MortgagesHome EquityAlt-APrimeWhole LoansCMO’sMezzanine LendingDerivatives

High Grade CreditAgenciesUS TreasuriesNon-Dollar TreasuriesRepoFuturesInterest Rate Derivatives

GovernmentsAgenciesUS TreasuriesNon-Dollar TreasuriesRepoFuturesInterest Rate Derivatives

Emerging MarketsSovereignsCorporateAsset-Backed SecuritiesDirect LendingDerivativesProject FinanceStructured FinanceCommercial Real Estate

MunicipalsGeneral ObligationsLetters of CreditHealthcareMoral ObligationsProject FinanceRevenue BondsDistressedDerivatives

Trade Strategies and RiskTrade Strategies Return Sources Risk Characteristics Typical Risk Allocation

HY Commercial Paper Carry Low 10-30%

Default Arbitrage Carry and Price Action Low 10-20

Short HY Basket, Long HY Market Basket

Carry and Price Action Low 20-30

Index Carry Trading Carry Low 10

Long HY Loan Market, Short HY Loan Basket

Price Action and Carry Low 20

HY Arbitrage Price Action and Carry Medium 0-30

Intracapital Price Action and Carry Medium 10-20

Long/Short Market Subsectors

Price Action Medium 10

New Issues Price Action Medium 5

L/S Specific Names Price Action High 30

Long Specific names Price Action, Carry High 10

Short Specific Names Price Action and Carry High 10

HY Municipals Price Action and Carry High 5

Cash/Derivatives Basis Trading

Price Action and Carry High 5

Single Name Volatility Price Action High 5

Global Fixed Income Market

Risk Sector

Issues

Duration Treasuries; Global AAAsCredit High Yield, Distressed, Emerging MarketVolatility Mortgages

Currency Non-dollar sovereigns; AAAs

Credit/Distressed/High Yield Sector Opportunities

• Stable credit markets and economic growth

• Lack of integration across credit spectrum (inflection points)– Investment to high yield– High yield to distressed– Across capital structure– Across term structure of debt in a company

Correlation of Monthly Returns1991-2004

High Yield (1)

10 year Treasuries (2)

MBS (3) Three-Month Treasuries (4)

High Grade Corporates (5)

Stocks (6)

High Yield 1.00 0.06 0.295 0.0348 0.3123 0.5120

10 Year Treasuries

1.00 0.83 0.72 0.93 (0.04)

MBS 1.00 0.29 0.09 0.23

3-mos Treasuries

1.00 0.18 0.09

High Grade Corporates

1.00 0.12

Stocks 1.00

Notes:(1) ML High Yield Master Index(2) ML 10 Year Treasury Index(3) ML Mortgage-Backed Index(4) ML three-month Treasury Index(5) ML High Grade Index(6) Wiltshire 5000 Stock Index

Benefits of High Yield and Distressed Investing

• Capital appreciation and high current income

• Diversified returns from various asset classes

• Market liquidity• Lower volatility than

equities, other

Correlation to Treasuries and Corporate Securities

1992-2004 US IT Govt

US LT Govt

LB Aggregate Bond

CSFB High Yield Index

0.00 0.11 0.19

CSFB Lev Loan Distressed Index

-0.05 0.00 -0.01

High Yield Investment Thesis• Record new capital inflows, migration from other

asset classes• Interest rates near four decade lows

– Search for yield, income– Rising rates hurt Treasury/Corporate debt

• Default rate in decline after 2002 peak• New issue market biased to stronger credits• Improving corporate balance sheets, corporate

governance, disclosure• Increase presence of commercial banks in

underwriting and trading

High Yield Investment Thesis (Continued)

• HY market remains inefficient– Long only charter of majority of investor base– Limited price transparency– Price sensitivity to funds flows– Dealer dominated market; liquidity “gaps”– Market not integrated to other parts of the

capital structure

State of High Yield Distressed Markets

• Historically low spreads• Near record level of issuance• Default rate in 2004 fell from 3.2% to 1.2%

– Long term average of 4.4%– 1994-1998 average of 2.1%

• Credit quality of new issues deteriorated by ratings, leverage and coverage ratio– Maintain discipline in high lead; leads to

opportunities in distressed

Definition of Distressed Investing• Undervalued, under followed, out of favor of

oversold securities• Small to middle market companies• “Distressed” segment

– Companies in or near reorganization and/or default– Undervalued securities trading at deeply discounted

prices resulting from severe financial, operational or economic problems

• “Stressed” segment– Under followed or out of favor securities trading at

discounted prices resulting from cyclical or sector downturns, financial stress and uncertainties

Distressed Debt Opportunities• Low interest rates, thirst for yield

and improving economy led to record issuance of junk bond and leveraged loans in 2003-5

• Combined with mortality rates will yield high supply of distressed

Year Bonds B- or Lower

Leveraged Loans B+ or Lower

2002 3.4% 7.5%2003 10.1% 20.8%2004 20.6%

(record)34.5% (record)

Years After Issuance Until Default

Rating

B Marginal Default Rate

2.9% 6.9% 7.4%

Cumulative Default Rate

2.9% 9.5% 16.2%

CCC Marginal DR 8.0% 15.6% 19.6%

Cumulative DR 8.0% 22.3% 37.5%

Credit Markets and Credit Derivatives

• Equity declines drove re-allocations to fixed income– Simultaneously government yields

decreased to all time lows– Credit default rates neared all time highs– Pension fund shortfalls (Focus on ALM)

• Credit markets are increasingly complex– Universe of assets is expanding rapidly– Spread products are becoming more complicated– Limited headcount to cover expanding

number of issues

Market Forces Change the Rules of Credit Investing

Currently Very Few Easy Opportunities

• End of the bear credit market in 2003

• Spreads have tightened to extreme levels

– Lowest since 1998• Demand still high

– Non-traditional investors Source: S&P

Outperformance Is More Demanding Than Ever

• Are we being correctly compensated?– Risk premium close to zero

• How does a long-only investor win/outperform?– Spreads have nowhere to go

• Move to– Lower-quality / higher-yielding– Find names with value still

• Asset selection is key

• Recent market environment

• New market-implied techniques to manage credit risk

• Introduction to the BDP (Barra Default Probability)

• Practical Examples

• Questions and answers

Discussion Outline

Market-Implied Measures Provide Additional Insight

Market-implied measures from the: Equity Market – Barra Default Probabilities (BDP) Bond Market – Barra Implied Ratings (BIR) Derivatives Market – Credit Default Swaps (CDS)

Coming soon…Crossover –Empirical Credit Risk (ECR)

Equity Risk Implied Spreads (ERIS)

Merton’s Structural Model of Default

• Default occurs at debt maturity if the firm valueis below the liabilities value

• We thus need– A model of firm value process– Estimate of default point

• Merton identified equity as being long a call option on the firm value

• Merton identified a bond as being short a put option on the firm value

Merton’s Structural Model of Default

0

D

V0

No Default

Probability of Default

Default

T

Agenda• The Credit Market

• Single name credit

• Correlation products

• Latest Innovation

• Risk Vision

Agenda• The Credit Market

• Single name credit

• Correlation products

• Latest Innovation

• Risk Vision

The Market of Credit• Size and sophistication of market has

grown enormously- Notional exceed $2 trillion - Single name (CDS, CLN) to full blown

portfolio based instruments (FtD, Synthetic loss tranches, CDO squared)

• Initially used by bank loan managers to hedge

• Now: insurance companies, hedge funds, asset managers, etc

Credit Derivatives• Instruments whose payoff is a function

of a reference assets credit characteristics

• Transfer the ownership of credit risk between buyers (of protection) and sellers (of protection)

• Diversification, yield enhancement

• Credit risk is traded independently of the instruments that generate the risk

Agenda• The Credit Market

• Single name credit

• Correlation products

• Latest Innovation

• Risk Vision

Single Name Credit Modelling• Structural approach: default when the company asset value

is less than its liabilities

• Spread relies on the internal structure of the company

• Can’t exactly fit a spread curve and can’t be used to price complex credit derivatives

• Reduced-form approach: the credit process is directly modelled via its probability of occurence

• Flexibility to fit a spread curve and extendable to price complex credit derivatives

Credit Default Swaps

• Most common credit derivative (over 50% of the market)

• Provides protection against default of a reference entity (isolates credit risk component)- Protection buyer retains market exposure

of reference entity- Protection seller gets leveraged exposure

to reference entity

Agenda• The Credit Market

• Single name credit

• Correlation products

• Latest Innovation

• Risk Vision

Correlation Products Modelling• Contracts that reference the default of more than one obligor• One of the fastest growing areas of credit derivatives

– nth-to-Default Baskets– CDO’s (static, managed, synthetic etc)

• Methodologies used to price these instruments– Default-time simulation (Normal, t, Archimedean copulas)– Semi-analytical approach

• The normal copula is the “benchmark” model for multi-obligor credit derivatives

Collateralised Debt Obligations• Application of securitisation technology

– Synthetically transferring assets off balance sheet via credit derivatives

• Asset pool is divided into tranches– Tranches have different risk/return characteristics – Payment to tranches is subordinated

• Risk on a CDO arises from the loss distribution of the underlying asset pool– Characteristics of individual underlying’s – Joint correlated behaviour of underlying’s

Agenda• The Credit Market

• Single name credit

• Correlation products

• Latest Innovation

• Risk Vision

Latest Innovation• CDS options• Default Swaptions• Credit Default Swap Index (Trac-x,

iBoxx)• CDO squared• Option on CDO tranches• Constant Maturity Default Swap

(CMDS)

Growth of Credit Default Swaps

2000 2001 2002 2003 2004

Global CDS 893 1,189 2,306 3,500 4,920

US Corporate (IG + HY)

3,359 3,835 4,094 4,462 4,636

Special Situations/Events• Identify Drivers/Destroyers of Value

– Overcapacity– Cyclical downturns– Rising raw material costs– Outsourcing manufacturing and service– Elimination of trade/tariff barriers– Aging populations in developed nations

• Extraordinary events– Re-capitalization– Restructurings– Liquidations– Spin-offs– Management Changes– Contests for Control; Proxy Contests– Stock Repurchase; Special Dividend– Business Repositioning– Regulatory review/investigation

Credit Analysis• Net income is not cash

– EBITDA• EBITDA/Interest Expense• Long Term Debt/EBITDA• (EBITDA-Capital Expenditures)/Interest• EBITDA/Revenues

– Interest Expense– Capital Expenditures– Free Cash Flow– Long Term Debt– Debt Repayment Requirements

• Qualitative Analysis– Quality of management– Equity sponsors– Event Risk (Consolidation; IPO; Technology or Regulation issues; Refinancing– Cyclical vs. Defensive industry– Ranking and Capital Structure– Bond Covenants

Examples of Multi-Strategy/Event Funds

Examples of Multi-Strategy Funds• Concordia

– 25% to distressed, 12% to credit relative value and 11% to volatility arbitrage.

• Wexford– 35% net long high yield against which they are carrying a 15%

duration weighted short in treasuries and a 25% long position in the distressed book; 25% net long special situation equities.

• Deephaven– 30% in relative value equity, 25% in convertible arbitrage, 20% in

event driven, 10% in distressed/ capital structure arbitrage, 5% in global macro and 5% in credit opportunities.

Etolian Capital Credit Arbitrage

Kellner DiLeo Cohen & Co• Investment Strategies (market neutral)

– Merger Arbitrage Fund– Convertible Arbitrage Fund– Distressed and High Yield Securities Fund– Special Situations Fund– Multi-Strategy Fund

• 40% Distressed/high yield• 23% Convertible Arbitrage• 27% Merger Arbitrage• 10% Special Situations

• Investment Professionals– CIO– Three Portfolio Managers – Four analysts Distressed Analyst

• $600 mm under management

Pinewood Capital Partners• Long, short and long/short positions in high yield

& investment grade debt, commercial and industrial loans, municipal bonds and exchange traded and OTC derivatives

• Staffing– CIO– Director of Reseach + 3 analysts– Head Trader– Risk Manager

Dickstein Partners

• Event Driven Situations– Merger Arbitrage– Distressed/High Yield Securities– Event Driven Strategies

• $450 Capital• Six Investment Professionals

Dickstein Partners

Canyon Capital

Canyon Organization

Canyon Credit Culture

Canyon Capital

Canyon Capital Direct Debt Investments

Canyon Capital

Angelo Gordon Alpha Credit Fund

• $8.5 billion in assets– 116 staff

• 56 investment professionals• 22 accounting/operations• 6 client service professional

• Percent of assets by strategy – Distressed securities – 30%– Leveraged loans (CLO) – 18%– Real estate – 18%– Convertible arbitrage – 12%– Merger Arbitrage – 4%– Cash – 10%– Other (Credit arbitrage, private equity, etc) – 18%

Angelo Gordon Alpha Credit Fund• Intra-Company Credit Arbitrage

– Senior vs. Subordinated– Parent vs. subsidiary– Short vs. long maturities– Bond vs. credit default swap– Bond vs. equity

• Inter-Company Arbitrage– Relative value within industry of credit rating– Individual credits vs. credit indices

• Outright Longs/Shorts– Longs/Shorts based on fundamental research

• Structured Transactions– Long/Short CDO hedging– Exploiting differences in instrument characteristics– Options on default swaps

Taconic Event Investing• Portfolio Composition

– Merger Arbitrage – 23%– Distressed/Stressed – 49%– Capital Structure Arbitrage – 32%

• Distressed/Stressed– Invest at the senior level (secured or senior); turns

into cash and/or credit worthy senior debt• Capital Structure Arbitrage

– Mispricing of different levels of stressed company’s capital structure• Bonds underpriced because of bondholder fear and equity

overpriced because of equity investors greed– Long senior bond and short junior bond or equity

Sagamore Hill Multi-Strategy Market Neutral Investment Fund

• Net Return Target = Risk Free + 5-8%

• Areas of Focus– Event Driven

• Distressed, Special Situations, Merger Arb.

– Relative Value• Capital Structure, Equity

Neutral, Long/Short Credit– Volatility Capture

• Convertibles, Volatility Trading

Strategy Current Allocation

Event 16%

Distressed 16%

Merger Arbitrage 15%

Capital Structure 14%

Long-Short Credit 7%

Equity Market Neutral

7%

Convertible Arbitrage

16%

Volatility Arbitrage 9%

Sagamore Hill Strategies: Event Driven

• Distressed– Fundamental-driven research of securities in, near or recently

emerged from bankruptcy– Domestic and European allocation– Deal sourcing; on the run; private opportunities

• Event Driven – Special Situations– Mispriced securities with clear valuation catalysts including

litigation, regulatory actions, spin-offs, refinancing– Excess returns from superior due diligence to capture excess

risk premiums created by risk averse investors• Merger Arbitrage

– Quantitative, fundamental and regulatory concerns– Use of options to mitigate risk and add value– Domestic and European focus

Sagamore Hill Strategies:Relative Value

• Capital Structure Arbitrage– Intra-company relative value among securities and derivatives

within a capital structure• Debt-equity, debt-option, senior-subordinated, structural arbitrage

and pari-passu• Balanced portfolio has minimal risk exposures

• Long-Short Credit– Fundamental credit research

• Asset values, business fundamentals, legal considerations and capital structure

– Domestic and European allocation– Isolate mispriced credit risk

• Equity Market Neutral– Equity Long/Short– Statistical quantitative equity portfolio construction

Sagamore Hill Strategy:Volatility Capture

• Convertible Arbitrage– Global portfolio– Mispriced volatility, credit risk, event risk– Quantitative and fundamental valuation techniques– Integration of convertible with other strategies within

the firm• Volatility Arbitrage

– Relative value trading (time spreads, skew and dispersion trades)

– Relative value between derivatives of related securities

– Focus on equity and foreign exchange markets

Structured Credit Programs

Mortgage Backed Securities• Value Proposition

– Mortgage market is large, liquid but not entirely efficient– Preferred Habitat by major players indifferent to relative value

• Banks buy to yield; shorter-duration mortgages• Homeowners borrow to buy/refinance; must pay current coupon• Mortgage servicers driven by hedging needs

• Mortgage Backed Securities and Related Instruments– Mortgage pools; adjustable rate loans; interest only loans;

balloon payment loans; non-performing loans; Commercial MBS; Private Label Mortgage Securities; CMOs, Mortgage derivatives, etc.

• Position Analysis– Risk/cheapness; Carry; Duration; Convexity– Identify shifts in investor preferences

JP Morgan Asset Management• Program Details

– Leverage of 10-15 times net assets– Return objective 8-12% over full market cycle (3-5

years)– $30 bln in long and long/short

• Organization– Three senior mortgage portfolio managers– Three quantitative research and risk management

analysts– Support from head of fixed income

Mortgage Backed SecuritiesCommon Types of Trades

• Coupon Swap: Long one coupon vs. duration-neutral short position in another coupon– Buy FNMA 6%, Sell FNMA 5.5%

• Trading Rolls: Long coupon in one settlement month vs. short same coupon in different month– Buy Sep GNMA 6%; Sell Oct GNMA 6%

• Butterfly: Long “center” short “wings”– Buy FNMA 6%, Sell FNMA 5.5% and 6.6%

• Agency-to-Agency: Long/short agencies in same coupon– Buy FNMA 5.5%, sell GNMA 5.5%

• 30-year vs. 15-year: Buy FNMA 20 year 5%, Sell FNMA 15 year 4.5%

• Mortgage vs. Treasuries or Swaps: Long (or Short) mortgage basis with expectation of spread compression (or widening) vs. Treasuries or swaps

Basis Yield Alpha Fund• Diversified Global Structured Credit Securities and Derivatives

– Asset Backed Securities (ABS)– Mortgage Backed Securities (MBS)– Collateralized Debt Obligations (CDO)– Collateralized Loan Obligations (CLO)

• Market Opportunities– Diversification benefits of pool of assets and high recovery rates– Lower default risk and credit migration– Uncorrelated to other asset classes– Premium from Illiquidity and complexity and because traditional fund

manager investment mandates stop at investment grade– Issuance in 2004 of $160 billion

• Personnel– Three portfolio managers– Four analysts

Concordia Advisors• Concordia Advisors hired Christopher Dillon and

James Wise, former co-heads of JPMorgan’s tax-exempt structured product group to manage a new fund, The Concordia Municipal Opportunities Fund, which will launch Oct. 1.

• Fixed income, interest rate neutral relative value fund will invest exclusively in the U.S. municipal bond market.

• Concordia has $1.2 billion in assets under management in eight other hedge funds.

Introduction to Asset Securitization

• “What is a Mortgage”• Mortgages as a Fixed Income investment• What else can you securitize?

Tradable Fixed Income Supply

U.S. Dollar Denominated Debt Market

Mortgages43%

ABS2% Sov/Supers

2%

Corporates13%

US Agency15%

US Treasuries25%

(2002 Information)

What are Mortgage Backed “Pass-Through” Securities?

• A number of similar mortgages (underlying collateral, design, rates and maturities) are combined into a single group

• Mortgage documents associated with this group are delivered to a custodian and are assigned an identification (pool) number

• A Mortgage Backed Security (MBS) is issued with a face amount equal to the cumulative outstanding principal balance of the mortgages (original balance)

• The mortgages that have been pooled together serve as the collateral for the security

• Most MBS are guaranteed and/or issued by a U.S. Government Agency (FNMA, Freddie Mac or GNMA)

+ + = SecuritizedMortgage Pool

or Pass-throughs

Agency Conforming MBS Origination Process

(next page)

Pooled by Mortgage Banks

Individual Mortgages Average Balance $125,000

Gross WAC: 8.50%

Judged for Sale by Balance (2000 cap of $275,000),

Documentation and Pay Histories

Mortgage Banking (Sells - Buys) Trading Desk

CMO Desk

E.G.: $500 FNMA issue

PO 6.5 yr

S Inverse Floater $10mm 6.5 yr

PA $250mm

5 yr PB

$50mm 10 yr

STRUCTURING CMOs REMICs

END PURCHASERS

Non-Conforming Conforminggg

Banks & Mortgage Servicers

TRADING

8.50% -.44 %

-.06 % 8.00%

(servicing fee) (guarantee fee)

8.50% -.25 %

-.25 % 8.00%

FNMA/FHLMC

FNMA or FHLMC 30 Yr.

GNMA BOUGHT BY AGENCIES

FHA/VA

P2 $100mm

4 yr

F Floater $40mm 6.5 yr

Z $50mm 20 yr

Agencies ~ 20%

Insurance Companies &

Regional Desks ~ 20% ~ 40-50%

Residential loans originated within the conforming Agency guidelines are guaranteed by an Agency, sold to the Street then either traded in pass-through form or used to structure a CMO…

Non-Conforming MBS Origination Process

(previouspage)

Pooled by M ortgage Banks

Ind iv idua l M o rtgagesA verage B a lance $125 ,000

G ross W A C : 8 .50%

Judged fo r S a le by B a lance(2000 cap o f $275,000 ),

D ocum enta tion a nd P ay H is to riesNon-Conforming

Either W hole LoansG eog raph ica l loca tions, z ip code, p roper ty type ,pay h is to ry , o rig ina l and curren t LTV ,occupancy, purpo se, insu rance

Ability to Pay W illingness to Pay Value of Asset

- Incom e verification- Asset verif ication- F inancial ra tios (FICOs)

- Tape data- Current 12 m onth pay

history- 30,60,90, 120+ day

delinquencies- Age

- B P O- A ppra isa l- G eography- Z ip C od e

D e t e r m i n e d B y:

LoanC harac te ris ticsR eview ed:

Or Senior/Subordinate96%

Aaa

4%

Subord ina tedTranche

Tranche by C reditA A 15% 13 .1 yrA 15% 13 .5 yrB B B 12% 13 .8 yrB B 19% 14 .2 yrB 12% 15 yrU R 27% 16 yr

Tranche by T im e

$50 m m 6 yr$30 m m 12 yr

Conforming

Credit Underw riters GSM C Custodian

Loans that do not conform to Agency standards are sold in “whole loan” form or structured into a senior/subordinate private label CMO…

Who Buys Mortgages?

Mortgage Security Holdings by Investor Type in 2002…

Pension Funds9%

Other8%

Life Insurance Co's11%

Banks 24%

Foreign Investors15%

Agencies32%

Amounts in $US billions

Banks and Agencies drive investment flows in the mortgage market, holding nearly 60% of all MBS

72

Overview of the U.S. Mortgage Securities Market

• Largest Sector of the U.S. Debt Market:– Aggregate current principal amount outstanding mortgage loans is over $4.9 trillion

as compared to about $3.3 trillion of government securities and $4.4 trillion of Corporate bonds.

– Mortgage backed securities (MBS) are an integral part of any broad portfolio exposure to the U.S. Government securities. The U.S. investment grade corporate debt market is less than 1.5 trillion in size.

• MBS can enhance portfolio performance significantly– Major mortgages indices have outperformed comparable duration U.S. Treasuries by

an average of more than 140 bp over the past 10 years.– The U.S. mortgage market consists of a wide array of securities to suit most investor

needs. A full range of credit qualities, durations, risk profiles and yields exist in this market.

• High Credit Quality– Most of the MBS market is issued by U.S. Government agencies which have an

implied AAA rating: GNMA issues carry full faith and credit of the U.S. Government, Fannie Mae and Freddie Mac have the implicit backing of the U.S. Government.

– Non-agency mortgage securities mostly consist of AA or better rated bonds. Lower rated securities (down to single-B) are also available.

What’s the catch?

• You are purchasing a product with an imbedded call option– Duration is very hard to determine.– Variability in Average Life can be substantial

• You are purchasing an amortizing product– Reinvestment of Principal monthly can reduce

yield.

"Duration" Deserves Special Focus in Mortgages...

• Modified duration, Macaulay duration, cashflow duration: all measure a mortgage's price sensitivity to rate movements, assuming the cashflows are held constant.– Usually not a good assumption in mortgage product owing to

prepayments– Durations often quoted as a percentage of modified duration

• Option-adjusted duration (OAD), model duration: measure price sensitivity for small rate movements, assuming constant OAS– Doesn't account for how securities actually trade– Reliant on prepayment model

• Empirical duration, EOAD: regression of performance vs rates– can be price or OAS vs rates– adjusted for volatility, slope of the curve

75

Prepayment Risk• Prepayment Option

– Any payments by borrower made in excess of scheduled principal payments are called prepayments

– The option is defined by the borrower's right to prepay all or part of the mortgage at any given time

– The uncertainty for the mortgage holder which results is termed prepayment risk

• Prepayment Motivation– Prepayment may occur for one of several reasons

• sale of property• default• refinancing

– Motivations beyond rational economic considerations play an important roll in assessing prepayment risk

• Risk for Mortgage Holder– Interest rate risk (re-investment risk): Should mortgage be fixed-rate,

market risk arises as a result of prepayment if rates fall and coupons are above market

– Liquidity risk: Should mortgage portfolio be securitized for debt issuance, prepayment implies the need to raise new financing

Duration and Convexity

• Duration (simply):

• Convexity is the change in Duration as yields change

yield

price

2 3 4 5 6 7 80

5

10

15

20

25

30

35

40

Yield (%)

gain fromconvexity(negative)

2 3 4 5 6 7 85

10

15

20

25

30

35

40

45

Yield (%)

gain fromconvexity

Price PricePositive Convexity Negative Convexity

Options and Convexity

• If you are long a call option – are you long gamma or short gamma?

• Why is being long an MBS similar to being short a call option? Who are you short this option to?

• Can you hedge this with options?