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I am working on hedging agency MBSs using treasury bonds. So my question raise as which treasury bond should more likely be a hedging underlying of a MBS. What is the matching criteria usually for MBS hedging? Duration matching, coupon matching, maturity matching, or others.

Any MBS hedging opinions comments are welcome! I am using optimal monte carlo to do the hedge, so I need a more related hedging instrument.

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What do you mean by optimal monte carlo? Duration matching is usually the standard. I know some also use swaptions to match the increase in the swap yields (which is linked to prepayment speed) – adam May 5 '14 at 6:37
@adam Great! Thanks adam! Someone alive! Optimal monte carlo basically is an optimization process for each time step in MC, usually taking the advantage of known final payoff and walk backwards, but here focuses on the hedging wealth change distribution at each time step, by minimizing the hedging wealth volatility, and constrain on wealth change expectation, using numerical approximation to solve option value and walk through, in the end based on the entire wealth change distribution to make better decision of pricing. I am still working on it, and apologize for my bad explanation. – TomHan May 5 '14 at 11:39
up vote 0 down vote accepted

Cheapest to deliver treasury bonds as hedging underlying would be the most related instrument I can think of for your Monte-Carlo type. This leads to matching via conversion factors. I am basing my answer to the similarities of your method to Monte-Carlo tree search.

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Great! @user7056 your answer is very practical, I think that is what used in real life, thanks! – TomHan Jun 28 '14 at 20:22

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