Hedging mortgage risk with T-bond futures and options: a case study

Pronounced upward movements in interest rates can result in substantial losses for financial institutions which hold fixed interest rate assets. The purpose of this study is to empirically evaluate the effectiveness of alternative hedging strategies using Treasury bond futures and futures options in reducing the risk of holding mortgage positions;A simulation of Treasury bond futures options prices is undertaken using the Black model for pricing call options and the put-call parity equation for pricing put options. The estimated put prices are then used to estimate the risk-return distributions of put and call hedged positions. Alternative strategies which are evaluated in this study are hedging the cash position with Treasury bond futures contracts and the risk minimizing hedge ratio, hedging with futures contracts and stop orders on the contracts, hedging with futures contracts and buying call options on the contracts, and hedging with put options on the futures contracts. For each of the alternative options hedges the risk-return distributions are determined for different exercise prices of the options. The alternative strategies are then evaluated by comparing their respective risk-return distributions.