Pricing Mortgage-Backed Securities in a Multifactor Interest Rate Environment: A Multivariate Density Estimation Approach

Posted: 21 Apr 1995

See all articles by Jacob Boudoukh

Jacob Boudoukh

Interdisciplinary Center (IDC) Herzliyah; AQR Capital Management, LLC

Matthew P. Richardson

New York University (NYU) - Department of Finance; National Bureau of Economic Research (NBER); AQR Capital Management, LLC

Richard Stanton

University of California, Berkeley - Haas School of Business

Robert Whitelaw

New York University; National Bureau of Economic Research (NBER)

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Abstract

There have been recent, well-documented cases of financial institutions and investment groups incurring huge monetary losses on their mortgage-backed security (MBS) portfolios. This vulnerability is partly due to the complexity of MBS pricing. Homeowners have the option to prepay their mortgages and refinance the property at any time; hence, MBS investors are implicitly buying a fixed-rate bond and writing a call option on this bond. Furthermore, prepayment of mortgages (and thus the timing and magnitude of the MBS's cash flows) can occur not only when rates fall, but also for reasons not related to the interest rate option. This paper develops a nonparametric, model-free approach to the pricing of MBSs, using multivariate density estimation (MDE). Our goal is to investigate the relation between MBS prices and interest rates. While the usual methods for valuing MBSs are highly dependent on specific assumptions about interest rates and prepayments, this method yields informative results without requiring such assumptions. The MDE estimation suggests that weekly MBS prices from January 1987 to May 1994 can be well described as a function of the level and slope of the term structure. We analyze how this function varies across MBSs with different coupons and investigate the sensitivity of prices to the two factors.

JEL Classification: G12, G13, G21

Suggested Citation

Boudoukh, Jacob and Richardson, Matthew P. and Stanton, Richard H. and Whitelaw, Robert F., Pricing Mortgage-Backed Securities in a Multifactor Interest Rate Environment: A Multivariate Density Estimation Approach. Available at SSRN: https://ssrn.com/abstract=6142

Jacob Boudoukh (Contact Author)

Interdisciplinary Center (IDC) Herzliyah ( email )

P.O. Box 167
Herzliya, 46150
Israel

AQR Capital Management, LLC ( email )

Greenwich, CT
United States

Matthew P. Richardson

New York University (NYU) - Department of Finance ( email )

44 West 4th Street
Suite 9-190
New York, NY 10012-1126
United States
212-998-0349 (Phone)
212-995-4233 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

AQR Capital Management, LLC ( email )

Greenwich, CT
United States

Richard H. Stanton

University of California, Berkeley - Haas School of Business ( email )

Haas School of Business
545 Student Services Building #1900
Berkeley, CA 94720-1900
United States
(510) 642-7382 (Phone)
(510) 643-1412 (Fax)

Robert F. Whitelaw

New York University ( email )

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States
212-998-0338 (Phone)
212-995-4233 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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