Funding Liquidity and the Valuation of Mortgage-Backed Securities

77 Pages Posted: 29 Mar 2021 Last revised: 31 Mar 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 relationship between funding liquidity and the valuation of mortgage-backed securities. Most of the financing for mortgage-backed securities occurs through a trade known as a dollar roll, the simultaneous sale and purchase of forward contracts on mortgage-backed securities that is analogous to a repurchase agreement. We develop a four-factor no-arbitrage model for valuing mortgage-backed securities that allows for the valuation of dollar rolls. Unlike previous models of the dollar roll, we allow for the possibility of a prepayment risk premium. We develop a new measure of mortgage specialness that is independent of prepayment risk premia and agency credit spreads. We find that specialness is related to measures of balance sheet constraints and primary dealer positions in mortgage-backed securities.

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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