“When the Fed raised the overnight borrowing rate from 3% to5.5% in 1994,” notes Hui-Chien Chang, director of the portfoliomanagement group, “the Barclays' U.S. aggregate bond index had adismal return of -2.94%.” That was not the kind of loss Googlecould accept.

Like any fixed-income security, MBS prices move inversely tointerest rates, so rising rates depress prices. Agencymortgage-backeds have little perceived credit risk because they areissued by agencies of the U.S. government, but they have prepaymentrisk. The securities are backed by home mortgages and homeownerscan pay off their mortgages at any time, so the duration is notfixed. Higher rates would discourage prepayments, lengthening theduration of the securities and making their price drop even more.Google needed a hedging strategy and an appropriate hedginginstrument.

It found its hedge in the to-be-announced (TBA) market, which isliquid and transparent. In a TBA trade, a buyer and seller agree ongeneral terms such as the type of security, the coupon, face valueand price, but not the specific pool of mortgages. Trades settleonly once a month. Until two days before settlement, sellers arefree to choose which pool of mortgages to offer, so naturally theypick the worst-performing pool. This worst-to-deliver option isunderstood and priced into the trade.