Knowledge that Transforms

Multivariate density estimation (MDE) suggests that mortgage-backed security (MBS) prices can be well described as a function of the level and slope of the term structure. We analyze how this function varies across MBSs with different coupons. An important finding is that the interest rate level proxies for the moneyness of the option, the expected level of prepayments, and the average life of the cash flows, while the term structure slope controls for the average rate at which these cash flows should be discounted. Though the origination and prepayment behavior of mortgages differ substantially across coupons, there remains an unexplained common factor in MBS prices. This factor does not seem to be related to the usual suspects and therefore presents a puzzle to financial economists.

Swedish government lottery bonds have coupon payments determined by lottery. They offer a unique opportunity to study a security with uncertain payoffs having a known, observable distribution. The risk associated with the lotteries is idiosyncratic by construction and should not command a risk premium in equilibrium. The bonds are traded in two forms, allowing us to evaluate the rewards to bearing extra lottery risk. Despite its idiosyncratic nature, we find prices appear to reflect aversion to this risk. We evaluate the empirical determinants of this differential pricing and possible explanations for it.

This article develops and tests a structural model of intraday price formation that embodies public information shocks and microstructure effects. We use the model to analyze intraday patterns in bid-ask spreads, price volatility, transaction costs, and return and quote auto-correlations, and to construct metrics for price discovery and effective trading costs. Information asymmetry and uncertainty over fundamentals decrease over the day, although transaction costs increase. The results help explain the U-shaped pattern in intraday bid-ask spreads and volatility, and are also consistent with the intra-day decline in the variance of ask price changes.