Pricing Mortgage-Backed Securities in a Multifactor Interest Rate Environment: A Multivariate Density Estimation Approach

Abstract

This paper develops a nonparametric, model-free approach to the pricing of mortgage-backed securities (MBS), using multivariate density estimation (MDE) procedures to investigate the relation between MBS prices and interest rates. While the usual methods for valuing MBSs are highly dependent on specific assumptions about interest rates and prepayments, this method will yield consistent results without requiring such assumptions. The MDE estimation suggests that weekly MBS prices from January 1987 to May 1994 can be well described as a function of the level slope of the term structure. We analyze how this function varies across MBSs with different coupons and investigate the sensitivity of price to the two factors. As an application, we use the estimated relation to hedge the interest rate risk of MBSs. These hedging results compare favorably with other commonly used hedging methods.