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Mortgage Hedging in Fixed Income Markets

  • Aytek Malkhozov
  • Philippe Mueller
  • Andrea Vedolin
  • Gyuri Venter

We study the feedback from hedging mortgage portfolios on the level and volatility of interest rates. We incorporate the supply shocks resulting from hedging into an otherwise standard dynamic term structure model, and derive two sets of predictions which are strongly supported by the data: First, the duration of mortgage-backed securities (MBS) positively predicts excess bond returns, especially for longer maturities. Second, MBS convexity increases yield and swaption implied volatilities, and this effect has a hump-shaped term structure. Empirically, neither duration, nor convexity are spanned by yield factors. A calibrated version of our model replicates salient features of first and second moments of bond yields

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Paper provided by Financial Markets Group in its series FMG Discussion Papers with number dp722.

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Date of creation: 2013
Date of revision:
Handle: RePEc:fmg:fmgdps:dp722
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  1. Hongjun Yan & Jinfan Zhang & Dong Lou, 2011. "Anticipated and Repeated Shocks in Liquid Markets," FMG Discussion Papers dp684, Financial Markets Group.
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  9. Stanton, Richard, 1995. "Rational Prepayment and the Valuation Mortgage-Backed Securities," Review of Financial Studies, Society for Financial Studies, vol. 8(3), pages 677-708.
  10. Nikolai Roussanov & Michael Michaux & Hui Chen, 2011. "Houses as ATMs? Mortgage Refinancing and Macroeconomic Uncertainty," 2011 Meeting Papers 1369, Society for Economic Dynamics.
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  13. Boudoukh, Jacob, et al, 1997. "Pricing Mortgage-Backed Securities in a Multifactor Interest Rate Environment: A Multivariate Density Estimation Approach," Review of Financial Studies, Society for Financial Studies, vol. 10(2), pages 405-46.
  14. Daniel O. Beltran & Maxwell Kretchmer & Jaime Marquez & Charles P. Thomas, 2012. "Foreign holdings of U.S. Treasuries and U.S. Treasury yields," International Finance Discussion Papers 1041, Board of Governors of the Federal Reserve System (U.S.).
  15. Philippe Mueller & Andrea Vedolin & Yu-min Yen, 2012. "Bond Variance Risk Premia," FMG Discussion Papers dp699, Financial Markets Group.
  16. Pierre Collin-Dufresne & Robert S. Goldstein, 2002. "Do Bonds Span the Fixed Income Markets? Theory and Evidence for Unspanned Stochastic Volatility," Journal of Finance, American Finance Association, vol. 57(4), pages 1685-1730, 08.
  17. Vasicek, Oldrich Alfonso, 1977. "Abstract: An Equilibrium Characterization of the Term Structure," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 12(04), pages 627-627, November.
  18. Acharya, Viral V & Lochstoer, Lars & Ramadorai, Tarun, 2009. "Limits to Arbitrage and Hedging: Evidence from Commodity Markets," CEPR Discussion Papers 7327, C.E.P.R. Discussion Papers.
  19. David F. Schrager & Antoon A. J. Pelsser, 2006. "Pricing Swaptions And Coupon Bond Options In Affine Term Structure Models," Mathematical Finance, Wiley Blackwell, vol. 16(4), pages 673-694.
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