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  • August 2014
  • Article
  • Journal of Financial Economics

Mortgage Convexity

By: Samuel G. Hanson
  • Format:Print
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Abstract

Most home mortgages in the United States are fixed-rate loans with an embedded prepayment option. When long-term rates decline, the effective duration of mortgage-backed securities (MBS) falls due to heightened refinancing expectations. I show that these changes in MBS duration function as large-scale shocks to the quantity of interest rate risk that must be borne by professional bond investors. I develop a simple model in which the risk tolerance of bond investors is limited in the short run, so these fluctuations in MBS duration generate significant variation in bond risk premia. Specifically, bond risk premia are high when aggregate MBS duration is high. The model offers an explanation for why long-term rates could appear to be excessively sensitive to movements in short rates and explains how changes in MBS duration act as a positive-feedback mechanism that amplifies interest rate volatility. I find strong support for these predictions in the time series of US government bond returns.

Keywords

Mortgages; Interest Rates; Volatility

Citation

Hanson, Samuel G. "Mortgage Convexity." Journal of Financial Economics 113, no. 2 (August 2014): 270–299. (Internet Appendix Here.)
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About The Author

Samuel G. Hanson

Finance
→More Publications

More from the Author

    • 2024
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    Supply and Demand and the Term Structure of Interest Rates

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    The Evolution of Banking in the 21st Century: Evidence and Regulatory Implications

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    • April 2024
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    Demand-and-Supply Imbalance Risk and Long-Term Swap Spreads

    By: Samuel G. Hanson, Aytek Malkhozov and Gyuri Venter
More from the Author
  • Supply and Demand and the Term Structure of Interest Rates By: Robin Greenwood, Samuel Hanson and Dimitri Vayanos
  • The Evolution of Banking in the 21st Century: Evidence and Regulatory Implications By: Samuel Gregory Hanson, Victoria Ivashina, Laura Nicolae, Jeremy C. Stein, Adi Sunderam and Daniel K. Tarullo
  • Demand-and-Supply Imbalance Risk and Long-Term Swap Spreads By: Samuel G. Hanson, Aytek Malkhozov and Gyuri Venter
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