Hedging in Fixed Income Markets

We study the feedback effect of mortgage-backed securities (MBS) hedging on the level and volatility of interest rates. We incorporate the demand/supply effects resulting from dynamic hedging into an otherwise standard dynamic term structure model and derive three sets of predictions which are strongly supported by the data: (i) MBS duration positively predicts excess bond returns, especially for longer maturities, (ii) MBS convexity increases the volatility of all yields and this effect has a hump-shaped pattern across maturities and (iii) the variation in bond return volatility driven by MBS hedging commands a variance risk premium. A calibrated version of our model replicates salient features of first and second moments of bond yields.

This event is an Erasmus Finance Seminar. The Erasmus Finance Seminar series brings prominent researchers in Finance from all over the world to Rotterdam.