The Cross Section of MBS Returns
60 Pages Posted: 9 Dec 2016 Last revised: 23 Sep 2018
Date Written: June 26, 2017
We present a simple, linear asset pricing model of the cross section of Mortgage- Backed Security (MBS) returns. MBS earn risk premia as compensation for their exposure to prepayment risk. We measure prepayment risk and estimate security risk loadings using real data on prepayment forecasts vs. realizations. Estimated loadings on prepayment risk are monotonically decreasing in securities’ coupons relative to the par coupon, as predicted by the fundamental effect of prepayment on the value of bonds trading above and below par. Prepayment risks appear to be priced by specialized MBS investors. In particular, we find convincing evidence that prepayment risk prices change sign over time with the sign of a representative MBS investor’s exposure to prepayment risk.
Keywords: Mortgages, Mortgage Backed Securities, Prepayment, Expected Returns
JEL Classification: G12, G21, G23
Suggested Citation: Suggested Citation