A Three-Factor Hedging Model for Mortgage-Backed Securities

Abstract

The purpose of this thesis is to evaluate the effectiveness of the three-factor model as a hedging tool for protecting mortgage-backed security values against changes in interest rates. Mortgage-backed securities offer lucrative yields compared to conventional bonds, but are impacted in a negative way by the volatility of interest rates. If these securities could be hedged in such a way that the total portfolio value remained relatively even regardless of the change in the yield curve, then their advantageous spreads could be captured profitably. The three-factor model quantitatively identifies the three principal components which are able to historically explain the greatest amount of variance in the yield curve (level shifts, twist shifts, and curvature shifts). Then, the principal components are used to calculate the optimal value of 2-year, 10-year, and 30-year Treasury futures to trade as hedging instruments in order to best retain the value of the portfolio under any yield curve shift. In this way, the three-factor model should be able to account for a greater percentage of interest rate volatility and outperform its two-factor and one-factor counterparts.