Cash-Forward Arbitrage and Dealer Capital in MBS Markets: COVID-19 and Beyond

48 Pages Posted: 28 Jul 2020

See all articles by Zhaogang Song

Zhaogang Song

Johns Hopkins University - Carey Business School

Haoyang Liu

Federal Reserve Bank of New York

Asani Sarkar

Federal Reserve Bank of New York

Jiakai Chen

University of Hawaii

Multiple version iconThere are 2 versions of this paper

Date Written: July 12, 2020

Abstract

Abstract We examine the economic mechanisms that limited arbitrage between the cash and forward markets of agency MBS, and whether asset purchases of the Federal Reserve (Fed) alleviated price dislocations. We find that the cash-forward basis, or the price difference between the cash and forward markets of agency MBS controlling for differences in fundamentals, widened significantly by $0.9 per $100 face value during the height of the COVID-19 crisis. The widening basis was accompanied by a significant increase in selling by customers in the cash market, indicating a “scramble-for-cash” following the liquidity shock. Dealers provided liquidity by increasing both their long cash and short forward positions significantly but the basis continued to widen, implying that balance sheet costs constrained dealers' inventories. We estimate dealers' average costs of holding inventory for five weeks as about $0.8. We also find that primary dealers affiliated with banks subject to Basel III liquidity regulations increased their positions more than others. The basis narrowed by about $0.7 following the Fed's MBS purchases in the forward market. We attribute this effect to the faster settlement schedules of the Fed's purchases, compared to the market convention, which allowed a faster deployment of capital. Overall, our results show that the combined liquidity constraints of investors and dealers led to severe price dislocations, and the Fed, in its role as the “dealer of last resort”, absorbed the liquidity demand that dealers lacked the capacity to meet.

Keywords: Arbitrage, Basis, Cohort, Dealer, Liquidity, MBS, Specified Pool, TBA

JEL Classification: D8, G2

Suggested Citation

Song, Zhaogang and Liu, Haoyang and Sarkar, Asani and Chen, Jiakai, Cash-Forward Arbitrage and Dealer Capital in MBS Markets: COVID-19 and Beyond (July 12, 2020). Available at SSRN: https://ssrn.com/abstract=3649559 or http://dx.doi.org/10.2139/ssrn.3649559

Zhaogang Song (Contact Author)

Johns Hopkins University - Carey Business School ( email )

100 International Drive
Baltimore, MD 21202
United States

Haoyang Liu

Federal Reserve Bank of New York ( email )

33 Liberty Street
New York, NY 10045
United States

Asani Sarkar

Federal Reserve Bank of New York ( email )

Research Department
33 Liberty Street
New York, NY 10045
United States
212-720-8943 (Phone)
212-720-1582 (Fax)

HOME PAGE: http://www.newyorkfed.org/research/economists/sarkar/pub.html

Jiakai Chen

University of Hawaii ( email )

Honolulu, HI 96822
United States

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