Funding Liquidity and the Valuation of Mortgage-Backed Securities

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