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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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File URL: http://www.lse.ac.uk/fmg/researchProgrammes/paulWoolleyCentre/workingPapers/dp722-PWC37.pdf
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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
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Handle: RePEc:fmg:fmgdps:dp722
Contact details of provider: Web page: http://www.lse.ac.uk/fmg/

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  1. Jean-Sébastien Fontaine & René Garcia, 2012. "Bond Liquidity Premia," Review of Financial Studies, Society for Financial Studies, vol. 25(4), pages 1207-1254.
  2. Hui Chen & Michael Michaux & Nikolai Roussanov, 2013. "Houses as ATMs? Mortgage Refinancing and Macroeconomic Uncertainty," NBER Working Papers 19421, National Bureau of Economic Research, Inc.
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  4. 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.
  5. Dwight Jaffee, 2003. "The Interest Rate Risk of Fannie Mae and Freddie Mac," Journal of Financial Services Research, Springer, vol. 24(1), pages 5-29, August.
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  11. Francis A. Longstaff, 2005. "Borrower Credit and the Valuation of Mortgage-Backed Securities," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 33(4), pages 619-661, December.
  12. Sumit Agarwal & John C. Driscoll & David Laibson, 2007. "Optimal Mortgage Refinancing: A Closed Form Solution," NBER Working Papers 13487, National Bureau of Economic Research, Inc.
  13. 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.
  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. 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.
  16. Dong Lou & Hongjun Yan & Jinfan Zhang, 2013. "Anticipated and Repeated Shocks in Liquid Markets," Review of Financial Studies, Society for Financial Studies, vol. 26(8), pages 1891-1912.
  17. 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.
  18. Vasicek, Oldrich, 1977. "An equilibrium characterization of the term structure," Journal of Financial Economics, Elsevier, vol. 5(2), pages 177-188, November.
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  20. 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.
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