MBS market vs Interest Rate job

[Joy Pathak]

Can anyone with knowledge comment on this...

What do you think the future is for MBS market? Would it be good to get into this side of the fixed-income?

What do you think of Interest rate derivatives... Is there a huge market for it? How does the future look? Especially IR options.

I am trying to get a better understanding of these two desks. Any insight is appreciated.

 

[Tsotne]

What do you think of Interest rate derivatives... Is there a huge market for it? How does the future look? Especially IR options.

When I was learning the derivatives markets, a professor kept telling us all the lectures that the interest rate derivatives is the most difficult and complex, most interesting and ideal for mathematical minds. As for fixed income, I'm studding it now and cannot give a clear insight but as far as the market for interest rate derivatives is concerned, it has always been one of the main part of derivatives trading and will always be. Let's look at the reality, everything can be connected to the interest rate - commodities, financial securities, natural resources, etc. since they all have interest rate risk but not everything can be connected to Microsoft common stock (I' m emphasizing on equity derivatives).

 

[financeguy]

Rates options is a huge market and it won't be going away at all. Rates vol has been huge recently and getting into USD rates derivatives trading would be great I think. Not much room for innovation in the market as its fairly developed, but will give you a background in macro, options theory, and technical product knowledge. Also it's not cyclical - during the crisis, desks like rates and FX saw increased flows as funds moved more into macro focus.

MBS would also be cool as that's still cutting edge, there's room for real innovation in the market, and spreads are enormous - but it's very cyclical and it's hard to say how and when exactly people will start getting paid again there (though of course it'll happen somehow at some point not too far away).

Personally I'd go for IR derivatives.

 

[Joy Pathak]

Rates options is a huge market and it won't be going away at all. Rates vol has been huge recently and getting into USD rates derivatives trading would be great I think. Not much room for innovation in the market as its fairly developed, but will give you a background in macro, options theory, and technical product knowledge. Also it's not cyclical - during the crisis, desks like rates and FX saw increased flows as funds moved more into macro focus.

MBS would also be cool as that's still cutting edge, there's room for real innovation in the market, and spreads are enormous - but it's very cyclical and it's hard to say how and when exactly people will start getting paid again there (though of course it'll happen somehow at some point not too far away).

Personally I'd go for IR derivatives.

Yeah. I am probably going to try and rotate through IR options and MBS desk. Thanks for the input. The MBS market seems to be picking up again though. Bunch of new deals came out recently.

 

[financeguy]

Yeah. I am probably going to try and rotate through IR options and MBS desk. Thanks for the input. The MBS market seems to be picking up again though. Bunch of new deals came out recently.

Out of curiosity, what sort of firm are you going to and what sorts of roles are they within these areas?

 

[Joy Pathak]

Out of curiosity, what sort of firm are you going to and what sorts of roles are they within these areas?

Summer Internship at a large european bank.

 

[financeguy]

Summer Internship at a large european bank.

Trading?

 

[bob]

I think there'll be lots of demand for inflation and IR products--especially for protection against rising rates--coming up. A vast hunk of the world's capital is held by vehicles with huge exposure to these two risk factors. Going forward, as has been pointed out this is probably the most difficult space in a quantitative sense and thus a good opportunity to differentiate yourself.

I personally think MBS is also a good place to go, especially residential. Not everyone will agree, most likely. If Congress makes good on its promise to unwind Fannie and Freddie, eventually the securitization volume for private deals will be immense, and understanding how the market and the business functions in as many of its Byzantine details as you can learn could definitely be a help in the long term. Plus, again, basically every real-money investor on Earth is up to their ears in this stuff, so you can't go wrong knowing about it.

 

[ThinkDifferent]

whatever happens to MBS products most IR derivatives are there to stay. Also, from the modelling perspective I find IR modelling more interesting.

 

[Tsotne]

IR derivatives are more complex to model in various phenomena rather than MBS ( it is also interesting though). As I know IR derivatives are one of the most difficult area so proportionally interesting as well. Demand for IR derivatives quant is higher as I believe than MBS.

 

[financeguy]

why's everyone saying that IR derivatives are so much more complex than MBS? from what I understand asset backed derivatives are plenty complicated, with structured transactions being so bespoke, having embedded optionality, taking IR paths as inputs to valuation (and so require rates modeling themselves), etc.. what exactly makes rates derivatives so much more complex than the other main asset classes like equities and fx?

 

[Tsotne]

why's everyone saying that IR derivatives are so much more complex than MBS? from what I understand asset backed derivatives are plenty complicated, with structured transactions being so bespoke, having embedded optionality, taking IR paths as inputs to valuation (and so require rates modeling themselves), etc.. what exactly makes rates derivatives so much more complex than the other main asset classes like equities and fx?

I must disagree. Haven't you seen simplified problems at banks or other financial institutions fixing the MBS modeling while making hundreds of assumptions about the interest rate fluctuations? Which are not based on particular forecasting technique. If they were to make some math/statistical modeling of IRs then this would break the whole pricing and modeling of MBSs. I can provide much examples where predicting a stochastic path of interest rates just doesn't fit in pricing MBSs. So they do the following basically: So called FED watchers are being given a pretty hard job to chase the meeting of FOMC and gather all the information released before FOMC can make decision and try to predict whether FED is gonna increase the money supply or vise versa. And the interest rate movements are basically modeled by predicting the level of expansionary/contractionary monetary policy which affects the IRs but not modeling the IR directly. And in case of IR derivatives, they don't even watch FED presumed decisions, rather construct complex mathematical modeling relying much on historical data and stochastic processes which is harder to evaluate than predicting monetary policy given all the economic data in the country. So I think that the following statement: "MBS includes IR modeling so MBS is harder than IR" is not the case. The difficulty arises when pure math comes to the rescue which happens to be the case in IR modeling.

I have come across one very interesting problem while studding IR derivatives and I'll search for it and post if I find. That'll probably remove all doubts regarding the IR difficulty.

Best
Tsotne

 

[ThinkDifferent]

sure, MBS are very involved in terms of structuring. Modeling of IR (the math part of it, the number of approaches, number of issues to deal with) is more involved though.
As for IR modelling is

much more complex than the other main asset classes like equities

, I wouldn't say that.
After all, you can make things as complex as you wish, so it's rather subjective.
However, generally, IR modelling is considered as more involved for a number of reasons.

Underlyings:
What is the main modeling object in equities? Underlying (stock).
In rates there a number of underlyings to model (Libor rates, swap rates). In addition, those have different tenors etc.
Also the object being modeled could be something observable (libor, swap rate etc) or some theoretical building block (short rate, instantaneous forward rate).

Calibration:
Starts with a curve construction, which in itself is rather tricky and, typically is built from\ three types of products (cash rates, futures, swaps).
Then you have non-linear products. A market for caps, market for swaptions. In addition, (if you calibrating a multi factor model) you may throw in CMS spread options, which are rather liquid, CMS rates quotes are also available.


Then you have various issues to deal with: convexity problems (unnatural payment time, CMS convexity, non-standard tenor etc. ), spreads modeling (Libor-OIS spread, Libor-Libor basis spreads, CCY spreads), different discounting rates (i.e. pricing with collateral) etc. etc.

 

[Tsotne]

sure, MBS are very involved in terms of structuring. Modeling of IR (the math part of it, the number of approaches, number of issues to deal with) is more involved though.

That's exactly because of such difficulty and many steps and factors to take into account that they make many assumptions while modeling MBSs which simplifies matters. For example as I stated, while taking IR fluctuation into account, they construct some naive methods to account for. Not all though. But when modeling IR derivatives you concentrate on mathematical modeling to fit the reality which is very difficult. We can state similar steps when constructing the IR derivatives models. But the thing is that, when we say: MBS involves IRs and how can it be easier to model than IR itself" - I don't think it's correct.

But I completely agree with this phrase:

...you can make things as complex as you wish, so it's rather subjective.

Regards

 

[goldski]

Prepayment modelling can get a bit intense for MBS.

If its mathematical complication, equity derivatives can be just as complicated if not more than IR.

 

[Tsotne]

Prepayment modeling can get a bit intense for MBS.


If its mathematical complication, equity derivatives can be just as complicated if not more than IR.

In what sense? Stochastic modeling for equities can be time consuming and tedious requiring a great deal of work to be conducted but not much complexity involved. Generally believed, IRs in contrast can get stuck at some point and may require an analyst to call on for need some economists or qualitative analysts. I came across such occasion when having internship at a risk department of a bank. When quant's failed to construct any mathematical model to IR derivatives and had to use the assistance of qualitative analysts who simply verbally stated what could happen and that was all. Not much useful for risk management purposes but that was the only way. What I am saying by that is that when we compare due to their complexity: IR is strongly believed to be more complex while equity derivatives are found to be more tedious and time consuming.

 

[goldski]

In what sense? Stochastic modeling for equities can be time consuming and tedious requiring a great deal of work to be conducted but not much complexity involved. Generally believed, IRs in contrast can get stuck at some point and may require an analyst to call on for need some economists or qualitative analysts. I came across such occasion when having internship at a risk department of a bank. When quant's failed to construct any mathematical model to IR derivatives and had to use the assistance of qualitative analysts who simply verbally stated what could happen and that was all. Not much useful for risk management purposes but that was the only way. What I am saying by that is that when we compare due to their complexity: IR is strongly believed to be more complex while equity derivatives are found to be more tedious and time consuming.

Constructing Vol surfaces and pricing options through them. Not trivial. Try reading Jim Gatherals Vol Surface book.

 

[Tsotne]

I wish to get a IR derivatives job in future. Seems more attractive than MBS for me. We moved off the topic while arguing the difficulty involved when modeling both of them. The original question was about the future trends of MBS markets and IR derivatives. Generally I know much more about IRs and perhaps that's because I strongly suggest it while keeping to ignore the resistive arguments. That's the natural expression but to be objective I still find IR more complex from the advices I have heard from professors while studding and more interesting. As for the future trend, I might have stated above that you can search for the demand for IR derivatives quants and it seems to be higher than MBS professionals.

Best

 

[Joy Pathak]

Really interesting discussion. Turns out I will be in oil and gas in the summer and then onto IR or MBS desk in fall so I still have some time to learn more about each.

 

[ThinkDifferent]

Constructing Vol surfaces and pricing options through them. Not trivial. Try reading Jim Gatherals Vol Surface book.

I read that book. It is a very neat collection of results on the relationships between local vol / implied vol / stochastic vol. It's very insightful.
The thing is, those three notions you have in rates as well. And they are treated and viewed in a similar way.

One modeling aspect that seem to be more widely used in equities or FX than in rates is jumps. But then again, you can model jumps (in the level of rates as well as vol) in IR as well (Rebonato vol&correlation book provides a few ways of doing that.....still not widely used in the industry though).

You can even make an argument (a rather silly though ) that books on IR modeling are thicker than those for equities.

The clear winners are:
I.The latest edition of Brigo&Mercurio (990 pages).
II. Rebonato book "Volatility&correlation" (800 pages)
III. Three thick volumes of "IR modeling" by Andersen&Piterbarg. (should really be the winner was it a one book )