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Understanding Mortgage Spreads

Author

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  • Nina Boyarchenko
  • Andreas Fuster
  • David O Lucca

Abstract

Because most mortgages in the United States are securitized in agency mortgage-backed securities (MBS), yield spreads on MBS are a key determinant of homeowners’ funding costs. We study variation in MBS spreads in the time series and across securities and document that MBS spreads show a pronounced cross-sectional smile with respect to the securities’ coupon rates. We present a new pricing model that uses “stripped” MBS prices to identify the contribution of non-interest-rate prepayment risk to spreads and find that this risk explains the smile, whereas the time-series spread variation is mostly accounted for by nonprepayment risk factors.Received March 30, 2015; editorial decision November 21, 2018 by Editor Leonid Kogan. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.

Suggested Citation

  • Nina Boyarchenko & Andreas Fuster & David O Lucca, 2019. "Understanding Mortgage Spreads," Review of Financial Studies, Society for Financial Studies, vol. 32(10), pages 3799-3850.
  • Handle: RePEc:oup:rfinst:v:32:y:2019:i:10:p:3799-3850.
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    File URL: http://hdl.handle.net/10.1093/rfs/hhz004
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    References listed on IDEAS

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    Citations

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    Cited by:

    1. Yuriy Kitsul & Marcelo Ochoa, 2016. "Funding Liquidity Risk and the Cross-section of MBS Returns," Finance and Economics Discussion Series 2016-052, Board of Governors of the Federal Reserve System (U.S.).
    2. Mikhail Chernov & Brett R. Dunn & Francis A. Longstaff, 2018. "Macroeconomic-Driven Prepayment Risk and the Valuation of Mortgage-Backed Securities," Review of Financial Studies, Society for Financial Studies, vol. 31(3), pages 1132-1183.
    3. Christopoulos, Andreas D. & Jarrow, Robert A., 2018. "CMBS market efficiency: The crisis and the recovery," Journal of Financial Stability, Elsevier, vol. 36(C), pages 159-186.
    4. Andreas Fuster & Stephanie Lo & Paul S. Willen, 2017. "The time-varying price of financial intermediation in the mortgage market," Working Papers 16-28, Federal Reserve Bank of Boston, revised 01 Jan 2017.
    5. Aytek Malkhozov & Philippe Mueller & Andrea Vedolin & Gyuri Venter, 2016. "Mortgage Risk and the Yield Curve," Review of Financial Studies, Society for Financial Studies, vol. 29(5), pages 1220-1253.
    6. Ospina, Juan & Uhlig, Harald, 2018. "Mortgage-Backed Securities and the Financial Crisis of 2008: a Post Mortem," CEPR Discussion Papers 12852, C.E.P.R. Discussion Papers.
    7. Peter Diep & Andrea L. Eisfeldt & Scott Richardson, 2016. "Prepayment Risk and Expected MBS Returns," NBER Working Papers 22851, National Bureau of Economic Research, Inc.
    8. Kim, Jong-Min & Kim, Dong H. & Jung, Hojin, 2020. "Modeling non-normal corporate bond yield spreads by copula," The North American Journal of Economics and Finance, Elsevier, vol. 53(C).
    9. Beltratti, Andrea & Benetton, Matteo & Gavazza, Alessandro, 2017. "The role of prepayment penalties in mortgage loans," Journal of Banking & Finance, Elsevier, vol. 82(C), pages 165-179.
    10. Zhiguo He & Arvind Krishnamurthy, 2018. "Intermediary Asset Pricing and the Financial Crisis," NBER Working Papers 24415, National Bureau of Economic Research, Inc.
    11. Jiakai Chen & Haoyang Liu & Asani Sarkar & Zhaogang Song, 2020. "Cash-Forward Arbitrage and Dealer Capital in MBS Markets: COVID-19 and Beyond ves," Staff Reports 933, Federal Reserve Bank of New York.
    12. Andrea L. Eisfeldt & Hanno Lustig & Lei Zhang, 2017. "Complex Asset Markets," NBER Working Papers 23476, National Bureau of Economic Research, Inc.

    More about this item

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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