Funding Liquidity and the Valuation of Mortgage-Backed Securities

77 Pages Posted: 29 Mar 2021 Last revised: 28 Sep 2022

See all articles by Brett Dunn

Brett Dunn

University of California, Los Angeles (UCLA)

Mahyar Kargar

University of Illinois at Urbana-Champaign

Geoffery Zheng

New York University (NYU) - New York University (NYU), Shanghai

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 us to value dollar roll trades based on exposure to (i) interest rates; (ii) prepayments; (iii) credit risk; and (iv) funding liquidity. We improve upon previous studies of MBS funding costs by incorporating maturity-dependent prepayment behavior and distinguishing between prepayment and interest rate risk. The model tightly fits the cross- section and term structure of MBS forward contracts, with a median RMSE of 15.9 cents per $100 notional, a 40|-.2.-| reduction over the prior literature. Our implied funding liquidity spread is strongly related to proxies for intermediary balance sheet costs and primary dealer MBS positions. We find that agency MBS is a segmented market whose financing costs are distinct from those in other large fixed income markets.

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 and Zheng, Geoffery, 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 ( email )

HOME PAGE: http://mahyarkargar.com

Geoffery Zheng

New York University (NYU) - New York University (NYU), Shanghai ( email )

1555 Century Ave
Shanghai, Shanghai 200122
China

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