Financial Markets in Pricing

Introduction:

Mortgage-backed securities (MBS) are financial instruments that derive their value from underlying pools of residential mortgages. These securities play a crucial role in the U.S. economy, allowing mortgage originators to spread risk and providing investors with an opportunity to invest in interest-rate contingent claims. However, pricing MBS is not as straightforward as it may seem due to the unique features associated with mortgage prepayments.

Key Factors in MBS Pricing:

1. Interest Rate Factors:
   • MBS prices are influenced by two primary interest rate factors:
     • Interest Rate Level: This factor proxies for the moneyness of the prepayment option. As mortgage rates change, borrowers may choose to prepay their existing mortgages. The interest rate level affects the expected level of prepayments and the average life of MBS cash flows.
     • Term Structure Slope: The slope of the term structure controls the average rate at which MBS cash flows should be discounted. It accounts for variations in interest rates across different maturities.
2. Complexity of MBS Pricing:
   • Fixed-rate mortgages offer fixed nominal payments, making their prices akin to pure discount bond prices.
   • However, the complexity arises from the fact that mortgage holders have the option to prepay their mortgages. MBS investors implicitly write a call option on a corresponding fixed-rate bond, introducing uncertainty into the timing and magnitude of cash flows.

Hedging Interest Rate Risk:

• Investors in MBS need effective hedging strategies to manage interest rate risk. One approach is to use a non-parametric technique called multivariate density estimation (MDE). This technique models MBS prices as a function of the interest rate factors mentioned earlier.
• By understanding the relationship between interest rates and MBS prices, investors can hedge against adverse interest rate movements.

Sources:

1. Boudoukh, J., Richardson, M., Stanton, R., & Whitelaw, R. F. (1998). The Pricing and Hedging of Mortgage-Backed Securities: A Multivariate Density Estimation Approach. Read the full paper here.

Conclusion:

The MBS market continues to evolve, and understanding the interplay between financial markets and MBS pricing is essential for investors and policymakers alike.

Feel free to explore the cited source for a deeper dive into the intricacies of MBS pricing!