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

53 Pages Posted: 21 Jul 2020 Last revised: 22 Sep 2020

See all articles by Jiakai Chen

Jiakai Chen

University of Hawaii

Haoyang Liu

Federal Reserve Bank of New York

Asani Sarkar

Federal Reserve Bank of New York

Zhaogang Song

Johns Hopkins University - Carey Business School

Multiple version iconThere are 2 versions of this paper

Date Written: July 1, 2020

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: G12, G14, G18

Suggested Citation

Chen, Jiakai and Liu, Haoyang and Sarkar, Asani and Song, Zhaogang, Cash-Forward Arbitrage and Dealer Capital in MBS Markets: COVID-19 and Beyond (July 1, 2020). FRB of New York Staff Report No. 933, Available at SSRN: https://ssrn.com/abstract=3651462 or http://dx.doi.org/10.2139/ssrn.3651462

Jiakai Chen

University of Hawaii ( email )

Honolulu, HI 96822
United States

Haoyang Liu (Contact Author)

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

Zhaogang Song

Johns Hopkins University - Carey Business School ( email )

100 International Drive
Baltimore, MD 21202
United States

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