Macroeconomic-Driven Prepayment Risk and the Valuation of Mortgage-Backed Securities. (14th December 2017)

• Record Type: Journal Article
• Authors: Chernov, Mikhail; Dunn, Brett R.; Longstaff, Francis A.
• Is Part Of: Review of financial studies. Volume 31:Number 3(2018)
• Page Start: 1132
• Page End: 1183
• Publication Date: 2017-12-14
• Subjects: Finance -- United States -- Periodicals; Finance -- Periodicals; 332
• DOI: 10.1093/rfs/hhx140
• Languages: English
• ISSNs: 0893-9454

Abstract

Abstract: We develop a three-factor no-arbitrage model for valuing mortgage-backed securities in which we solve for the implied prepayment function from the cross-section of market prices. This model closely fits the cross-section of mortgage-backed security prices without needing to specify an econometric prepayment model. We find that implied prepayments are generally higher than actual prepayments, providing direct evidence of significant macroeconomic-driven prepayment risk premiums in mortgage-backed security prices. We also find evidence that mortgage-backed security prices were significantly affected by Fannie Mae credit risk and the Federal Reserve's quantitative easing programs. Received May 10, 2016; editorial decision September 22, 2017 by Editor Stijn Van Nieuwerburgh.