Mortgage-backed arbitrage requires modeling borrower prepayment options and hedging them

Evidence

To identify arbitrage opportunities involving mortgage-backed securities, for example, one has to examine the extent of the “spread” of their yields over government bonds after taking into account the mortgage holders’ prepayment option. It is also necessary to work out how to hedge the pre-payment risk, for instance by purchasing interest-rate options. — Donald MacKenzie, An Engine, Not a Camera, 963

Categorization

• XREF: This is the concrete mechanism behind LTCM’s eventual fatal mortgage trades, connecting to LTCM-specific accounts like Lowenstein’s ‘When Genius Failed’. — connects to: Prepayment risk and agency status push mortgage-backed yields a point above Treasury yields — Donald MacKenzie, An Engine, Not a Camera: How Financial…, 958; Pre-Black-Scholes option valuation needed investor risk attitude as an unobservable input — Donald MacKenzie, An Engine, Not a Camera: How Financial…, 536
• DEFINE: Clarifies what the ‘spread’ premium and prepayment hedging actually involve in mortgage-backed arbitrage.

Broader Connections

• Pre-Black-Scholes option valuation needed investor risk attitude as an unobservable input #qualifies (0.72) — Donald MacKenzie, An Engine, Not a Camera, 536