Working Paper

Funding Liquidity Risk and the Cross-section of MBS Returns

Abstract: This paper shows that funding liquidity risk is priced in the cross-section of excess returns on agency mortgage-backed securities (MBS). We derive a measure of funding liquidity risk from dollar-roll implied financing rates (IFRs), which reflect security-level costs of financing positions in the MBS market. We show that factors representing higher net MBS supply are generally associated with higher IFRs, or higher funding costs. In addition, we find that exposure to systematic funding liquidity shocks embedded in the IFRs is compensated in the cross-section of expected excess returns| agency MBS that are better hedges to funding liquidity shocks on average deliver lower excess returns-and that these premiums are separate from the premiums associated with prepayment risks.

Keywords: Agency mortgage-backed securities; Dollar rolls; Implied financing rates; Liquidity; Expected returns; large-scale asset purchase programs;

JEL Classification: G1; G12; G19; E43; E58;

https://doi.org/10.17016/FEDS.2016.052

Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: Finance and Economics Discussion Series

Publication Date: 2016-06-07

Number: 2016-052

Pages: 42 pages