Macroeconomic-Driven Prepayment Risk and the Valuation of Mortgage-Backed Securities

Mikhail Chernov, Brett R. Dunn and Francis A. Longstaff

The Review of Financial Studies, 2018, vol. 31, issue 3, 1132-1183

Abstract: We develop a three-factor no-arbitrage model for valuing mortgage-backed securities in which we solve for the implied prepayment function from the cross-section of market prices. This model closely fits the cross-section of mortgage-backed security prices without needing to specify an econometric prepayment model. We find that implied prepayments are generally higher than actual prepayments, providing direct evidence of significant macroeconomic-driven prepayment risk premiums in mortgage-backed security prices. We also find evidence that mortgage-backed security prices were significantly affected by Fannie Mae credit risk and the Federal Reserve’s quantitative easing programs. Received May 10, 2016; editorial decision September 22, 2017 by Editor Stijn Van Nieuwerburgh.

Date: 2018
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Working Paper: Macroeconomic-Driven Prepayment Risk and the Valuation of Mortgage-Backed Securities (2016)
Working Paper: Macroeconomic-Driven Prepayment Risk and the Valuation of Mortgage-Backed Securities (2016)
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