Event Driven Hedge Funds

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 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 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

Capital Structure Arbitrage

Event Driven

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 Securities Equipment Commercial Future Flow Consumer Special Situations Direct Portfolio Lending Mezzanine Lending Distressed Derivatives CDOs Middle Market Loans High Yield Bonds Real Estate ABS CDO High Grade Commercial Real Estate Large Loans Subordinated Classes Direct Lending Special Situations Mezzanine Lending Credit Derivatives Correlation Trading Credit Default Swaps Baskets Indices Leveraged Credit Leveraged Loans Distressed Mezzanine Debt Special Situations Direct Placement High Yield Bonds Convertibles PIPES ETCs Derivatives

Residential Mortgages Home Equity Alt-A Prime Whole Loans CMOs Mezzanine Lending Derivatives

High Grade Credit Agencies US Treasuries Non-Dollar Treasuries Repo Futures Interest Rate Derivatives

Governments Agencies US Treasuries Non-Dollar Treasuries Repo Futures Interest Rate Derivatives

Emerging Markets Sovereigns Corporate Asset-Backed Securities Direct Lending Derivatives Project Finance Structured Finance Commercial Real Estate

Municipals General Obligations Letters of Credit Healthcare Moral Obligations Project Finance Revenue Bonds Distressed Derivatives

Trade Strategies and Risk

Trade Strategies HY Commercial Paper Default Arbitrage Short HY Basket, Long HY Market Basket Index Carry Trading Long HY Loan Market, Short HY Loan Basket HY Arbitrage Intracapital Long/Short Market Subsectors New Issues L/S Specific Names Long Specific names Short Specific Names HY Municipals Cash/Derivatives Basis Trading Single Name Volatility Return Sources Carry Carry and Price Action Carry and Price Action Carry Price Action and Carry Price Action and Carry Price Action and Carry Price Action Price Action Price Action Price Action, Carry Price Action and Carry Price Action and Carry Price Action and Carry Price Action Risk Characteristics Low Low Low Low Low Medium Medium Medium Medium High High High High High High Typical Risk Allocation 10-30% 10-20 20-30 10 20 0-30 10-20 10 5 30 10 10 5 5 5

Global Fixed Income Market

Risk Sector Issues
Duration Credit Volatility Currency Treasuries; Global AAAs High Yield, Distressed, Emerging Market Mortgages 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 Returns 1991-2004

High Yield (1) 10 year Treasuries (2)
0.06 1.00

MBS (3)

ThreeMonth Treasuries (4)

0.0348 0.72 0.29 1.00

High Grade Corporates (5)

0.3123 0.93 0.09 0.18 1.00

Stocks (6)

High Yield 10 Year Treasuries MBS 3-mos Treasuries High Grade Corporates Stocks

1.00

0.295 0.83 1.00

0.5120 (0.04) 0.23 0.09 0.12 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 0.19

CSFB High Yield Index CSFB Lev Loan Distressed Index

0.00

0.11

-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 Bor Lower 3.4% 10.1% 20.6% (record) Leveraged Loans B+ or Lower 7.5% 20.8% 34.5% (record)

2002 2003 2004

Years After Issuance Until Default Rating B Marginal Default Rate Cumulative Default Rate CCC Marginal DR 2.9% 2.9% 8.0% 6.9% 9.5% 15.6% 22.3% 7.4% 16.2% 19.6% 37.5%

Cumulative DR 8.0%

Credit Markets and Credit Derivatives

Market Forces Change the Rules of Credit Investing

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

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

Discussion Outline
Recent market environment New market-implied techniques to manage credit risk Introduction to the BDP (Barra Default Probability) Practical Examples Questions and answers

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)

Mertons Structural Model of Default

Default occurs at debt maturity if the firm value is 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

Mertons Structural Model of Default

No Default V0 D Default 0 T

Probability of Default

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 Cant exactly fit a spread curve and cant 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 CDOs (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 underlyings Joint correlated behaviour of underlyings

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

Extraordinary events

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

Qualitative Analysis

Examples of MultiStrategy/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 companys 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.
Strategy Event Distressed Merger Arbitrage Capital Structure Long-Short Credit Equity Market Neutral Convertible Arbitrage Volatility Arbitrage Current Allocation 16% 16% 15% 14% 7% 7% 16% 9%

Relative Value
Capital Structure, Equity Neutral, Long/Short Credit

Volatility Capture
Convertibles, Volatility Trading

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 Securities Common 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 JPMorgans 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

Mortgages 43%

US Treasuries 25%

US Agency 15% ABS 2% Corporates 13%

Sov/Supers 2%

(2002 Information)

What are Mortgage Backed Pass-Through Securities?

Securitized Mortgage Pool or Pass-throughs

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)

Agency Conforming MBS Origination Process

Individual Mortgages

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

Average Balance $125,000 Gross WAC: 8.50%

Pooled by Mortgage Banks

Conforming

Judged for Sale by Balance (2000 cap of $275,000), Documentation and Pay Histories

Non-Conforming

GNMA

BOUGHT BY AGENCIES
FHA/VA

8.50% -.44 % -.06 % 8.00%

(servicing fee) (guarantee fee)

8.50% -.25 % -.25 % 8.00%

FNMA/FHLMC

(next
FNMA or FHLMC 30 Yr.

TRADING

Mortgage Banking (Sells - Buys) Trading Desk CMO Desk

PO 6.5 yr

STRUCTURING
CMOs REMICs E.G.: $500 FNMA issue PA $250mm 5 yr PB $50mm 10 yr

P2 $100mm 4 yr

F Floater $40mm 6.5 yr S Inverse Floater $10mm 6.5 yr

Z $50mm 20 yr

END PURCHASERS

Agencies ~ 20%

Banks & Mortgage Servicers ~ 40-50%

Insurance Companies & Regional Desks ~ 20%

Non-Conforming MBS Origination Process

Individual Mortgages

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

Average Balance $125,000 Gross WAC: 8.50%

Pooled by Mortgage Banks

Conforming

Judged for Sale by Balance (2000 cap of $275,000), Documentation and Pay Histories

Non-Conforming

(previous page)

Either
Loan Characteristics Reviewed:
Ability to Pay

Whole Loans
Geographical locations, zip code, property type, pay history, original and current LTV, occupancy, purpose, insurance
Willingness to Pay Value of Asset

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

Credit Underwriters - Income verification - Asset verification - Financial ratios (FICOs)

GSMC - Tape data - Current 12 month pay history - 30,60,90, 120+ day delinquencies - Age

Custodian

- BPO - Appraisal - Geography - Zip Code

Or
96%

Senior/Subordinate
4% Tranche by Credit Tranche by Time Aaa $50 mm 6 yr $30 mm 12 yr Subordinated Tranche
AA A BBB BB B UR 15% 15% 12% 19% 12% 27% 13.1 yr 13.5 yr 13.8 yr 14.2 yr 15 yr 16 yr

Who Buys Mortgages?

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

Mortgage Security Holdings by Investor Type in 2002

Amounts in $US billions

Agencies 32%

Pension Funds 9%

Life Insurance Co's 11% Other 8%

Foreign Investors 15%

Banks 24%

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.

72

Whats 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

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

75

Duration and Convexity

Duration (simply):
price yield

Convexity is the change in Duration as yields change

Positive Convexity Price 45 40 35 30 25 20 15 10 5 2 3 4 5 6 7 8 gain from convexity Price 40 35 30 25 20 15 10 5 0 2 3 4 5 6 7 8 gain from convexity (negative) Negative Convexity

Yield (%)

Yield (%)

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?