Hedging in Fixed Income Markets
Abstract
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.
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