Incorporating the Dynamic Link Between Mortgage and Treasury Markets in Pricing and Hedging MBS

Abstract

The increase in the size of the mortgage market over the last few years has caused the link between mortgage and treasury markets to grow stronger, especially in a low interest rate environment. This has implications for practitioners who are concerned with the pricing and hedging of MBS portfolios. In this article, we introduce the change in the moneyness of the 30-year mortgage market as a variable to proxy the hedging needs of MBS portfolio holders. We couple this with a co-integration GARCH approach to price and hedge MBS, which results in better hedging effectiveness when compared to the traditional empirical duration-based hedges. We also provide evidence in favor of using a co-integration GARCH approach to effectively price MBS and 10-year Treasury note futures contracts.