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 and hedging of mortgage-backed securities (MBS), using multivariate density estimation procedures to investigate the relation between MBS prices and interest rates. While the usual methods of valuing MBSs are highly dependent on specific assumptions about interest rates and prepayment, this method will yield consistent results without requiring such assumptions. Weekly MBS prices from January 1987 to May 1994 can be well described as a function of the level and slope of the term structure. Using this estimated relation to hedge the interest rate risk of MBS gives results that compare favorably with other commonly using hedging methods.