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RFS Advance Access originally published online on December 4, 2007
Review of Financial Studies 2008 21(4):1689-1731; doi:10.1093/rfs/hhm062
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© The Author 2007. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please email: journals.permissions@oxfordjournals.org

The Causal Effect of Mortgage Refinancing on Interest Rate Volatility: Empirical Evidence and Theoretical Implications

Jefferson Duarte
University of Washington

Address correspondence to Jefferson Duarte, University of Washington, Box 353200, Seattle, WA 98195-3200; telephone: (206) 543-1843; e-mail: jduarte{at}u.washington.edu.

JEL Classification: G12, G13, G21


  Abstract

This article investigates the effects of mortgage-backed security (MBS) hedging activity on interest rate volatility and proposes a model that takes these effects into account. An empirical examination suggests that the inclusion of information about MBSs considerably improves model performance in pricing interest rate options and in forecasting future interest rate volatility. The empirical results are consistent with the hypothesis that MBS hedging affects the interest rate volatility implied by both options and the actual interest rate volatility. The results also indicate that the inclusion of information about the MBS universe may result in models that better describe the price of fixed-income securities.

I would like to thank Yacine Aït-Sahalia, Eduardo Canabarro, Bing Han, Alan Hess, Jon Highum, Avi Kamara, Jon Karpoff, Arvind Krishnamurthy, Haitao Li, Francis Longstaff, Paul Malatesta, Douglas McManus, Jorge Reis, Ed Rice, Pedro Santa-Clara, José Scheinkman, Eduardo Schwartz, Andy Siegel, Ken Singleton, an anonymous referee, as well as seminar participants at the 2004 Pacific Northwest Finance Conference, 2005 Allied Social Science Associations meeting, 2006 WHU Fixed Income Conference, Bank of Canada, Freddie Mac, Seattle University, Simon Fraser University, University of Florida, and University of Washington for valuable comments. All errors are mine.


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