Funding Liquidity and the Valuation of Mortgage-Backed Securities

72 Pages Posted: 29 Mar 2021 Last revised: 10 Nov 2021

See all articles by Brett Dunn

Brett Dunn

University of California, Los Angeles (UCLA)

Mahyar Kargar

University of Illinois at Urbana-Champaign - Department of Finance

Date Written: March 26, 2021

Abstract

We study the relation between funding liquidity and the valuation of mortgage-backed securities. Most MBS positions are financed through a trade known as a dollar roll, the simultaneous sale and purchase of MBS forward contracts. We develop a four-factor no-arbitrage MBS valuation model that allows for valuing dollar rolls. Unlike the previous studies of MBS funding costs, we allow for the possibility of a prepayment risk premium. The model-implied measure of MBS funding liquidity is independent of prepayment risk and agency credit spreads. The model tightly fits the cross-section and term structure of MBS forward contracts, with the median RMSE across the coupon stack and expiration dates of only 15.9 cents per $100 notional. Our model-implied funding liquidity spread is strongly related to proxies for intermediary balance sheet costs and primary dealer MBS positions.

Keywords: Mortgage-backed securities, funding liquidity, affine models, prepayment function, TBA contracts, dollar rolls

JEL Classification: G12, G13, G21

Suggested Citation

Dunn, Brett and Kargar, Mahyar, Funding Liquidity and the Valuation of Mortgage-Backed Securities (March 26, 2021). Available at SSRN: https://ssrn.com/abstract=3813212 or http://dx.doi.org/10.2139/ssrn.3813212

Brett Dunn

University of California, Los Angeles (UCLA) ( email )

405 Hilgard Avenue
Box 951361
Los Angeles, CA 90095
United States

Mahyar Kargar (Contact Author)

University of Illinois at Urbana-Champaign - Department of Finance ( email )

Champaign, IL 61820
United States

HOME PAGE: http://mahyarkargar.com

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