The Pricing and Hedging of Mortgage-Backed Securities: A Multivariate Density Estimation Approach
Kobi Boudoukh, New York University
Matt Richardson, New York University
Richard Stanton, University of California at Berkeley
Robert Whitelaw, New York University

Two papers were produced in connection with this project.

The first paper, “A New Strategy for Dynamically Hedging Mortgage-Backed Securities,” proposes and empirically evaluates a hedging strategy in which the hedge ratio is derived from estimates of the joint distribution of Mortgage-Backed Securities, T-Note futures, and concurrent macro-economic variables. The resulting dynamic hedge changes with changes in the macroeconomy. The results show that the method meaningfully reduces residual variation when compared to static methods.

The second paper, “Pricing Mortgage-Backed Securities in a Multifactor Interest Rate Environment: A Multivariate Density Estimation Approach,” shows that the prices of Mortgage-Backed Securities are well described by a function of the level and slope of the term structure, and by another hard-to-classify common factor. The interest rate level provides information about moneyness of the prepayment option, the expected level of prepayments, and the average life of the cash flows. The term structure slope provides information about the rate at which the cash flows should be discounted. (Accepted Winter 1997.)