Mortgage Risk and the Yield Curve
- Send correspondence to Andrea Vedolin, Department of Finance, London School of Economics, Houghton Street, WC2A 2AE London, UK; telephone: +44 20 7955 5017. E-mail: a.vedolin{at}lse.ac.uk.
Abstract
We study feedback from the risk of outstanding mortgage-backed securities (MBS) on the level and volatility of interest rates. We incorporate supply shocks resulting from changes in MBS duration into a parsimonious equilibrium dynamic term structure model and derive three predictions that are strongly supported in the data: (1) MBS duration positively predicts nominal and real excess bond returns, especially for longer maturities; (2) the predictive power of MBS duration is transitory in nature; and (3) MBS convexity increases interest rate volatility, and this effect has a hump-shaped term structure.
Received November 10, 2014; accepted December 8, 2015 by Editor Robin Greenwood.
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