The simple framework applied in the table allows investors to focus on whether the risk and leverage utilized in a given strategy and the hedged returns available in the market achieve the expected ROE and whether the stated returns are consistent with the true risk of the strategy and the hedged returns available in the market. As important, the framework allows investors to see how ROE can be distorted by unrealistic assessments of risk, leverage, and hedged returns.

Example
The appropriateness of the risk and leverage utilized within a given leveraged strategy can be analyzed by applying statistical processes to historical price data. One example of assessing capital at risk statistically is to regress the historical monthly TRR of a FNMA Current Coupon MBS Index on the historical monthly TRR of the Agency Master Index. The magnitude and frequency of the forecast errors can be used to formulate the net capital risk inherent in a strategy that features a long 30-year FNMA current coupon MBS position funded by a duration equivalent portfolio of Agency liabilities.

In this example, the ordered forecast errors show that the FN 30-year current coupon MBS TRR can be less than expected on a duration neutral basis by as much as 3.53%. For this leveraged MBS strategy using a level of capital of less 3.53% could imperil the solvency of the strategy. >>>