“When the Fed raised the overnight borrowing rate from 3% to 5.5% in 1994,” notes Hui-Chien Chang, director of the portfolio management group, “the Barclays' U.S. aggregate bond index had a dismal return of -2.94%.” That was not the kind of loss Google could accept.

Like any fixed-income security, MBS prices move inversely to interest rates, so rising rates depress prices. Agency mortgage-backeds have little perceived credit risk because they are issued by agencies of the U.S. government, but they have prepayment risk. The securities are backed by home mortgages and homeowners can pay off their mortgages at any time, so the duration is not fixed. Higher rates would discourage prepayments, lengthening the duration of the securities and making their price drop even more. Google needed a hedging strategy and an appropriate hedging instrument.

It found its hedge in the to-be-announced (TBA) market, which is liquid and transparent. In a TBA trade, a buyer and seller agree on general terms such as the type of security, the coupon, face value and price, but not the specific pool of mortgages. Trades settle only once a month. Until two days before settlement, sellers are free to choose which pool of mortgages to offer, so naturally they pick the worst-performing pool. This worst-to-deliver option is understood and priced into the trade.