Market Risk of Mortgage-Backed Securities with Consistent Measures

Posted: 31 Aug 2007

See all articles by Hsien-Hsing Liao

Hsien-Hsing Liao

National Taiwan University

Ren-Raw Chen

Fordham University - Gabelli School of Business

Tyler T. Yang

Federal Home Loan Mortgage Corporation (FHLMC) - Portfolio Management

Abstract

Due to the complex prepayment behavior, mortgage contracts and their derivatives are generally priced using Monte Carlo simulations. The typical approach used by the industry, which involves simulating interest rates under the risk-neutral measure and applying a physically measured prepayment function, is subject to the problem of internal inconsistency. This is the first paper that directly investigates the potential impact of this issue. Following the general equilibrium setting by Cox, Ingersoll and Ross, we incorporate the market risk price parameter to derive the physical interest rate process from an unobserved yield curve. This allows us to model mortgage values under the consistent physical measures of interest rates and prepayment functions.

By analyzing a default-free Ginnie Mae MBS, we find that the mixed measures lead to slower prepayment rate estimates and overpriced mortgage securities by approximately 5 percent. Further, there can be substantial biases in the duration and convexity measures depending on market condition and the particular security of interest. The internal inconsistency also leads to baised predictions of both expected and stressed returns for different investment horizons. Depending on the particular security, the bias in expected and stressed returns can be either positive or negative. These biases in risk estimates can introduce misallocation or risk-based capital and/or failure in hedging the market risk of a mortgage-related portfolio.

Suggested Citation

Liao, Hsien-Hsing and Chen, Ren-Raw and Yang, Tyler T., Market Risk of Mortgage-Backed Securities with Consistent Measures. Journal of Real Estate Finance and Economics, Vol. 36, No. 1, 2008. Available at SSRN: https://ssrn.com/abstract=1010738

Hsien-Hsing Liao

National Taiwan University ( email )

1 Sec. 4, Roosevelt Road
Taipei, 106
Taiwan

Ren-Raw Chen (Contact Author)

Fordham University - Gabelli School of Business ( email )

113 West 60th Street
Bronx, NY 10458
United States

Tyler T. Yang

Federal Home Loan Mortgage Corporation (FHLMC) - Portfolio Management ( email )

McLean, VA 22101
United States

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