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Mortgage Hedging in Fixed Income Markets

Aytek Malkhozov, Philippe Mueller, Andrea Vedolin and Gyuri Venter

FMG Discussion Papers from Financial Markets Group

Abstract: 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

Date: 2013
New Economics Papers: this item is included in nep-fmk, nep-spo and nep-ure
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