Asset pricing with cohort-based trading in MBS markets

Agency mortgage backed securities (MBS) with diverse characteristics are traded in parallel with individualized contracts in the specified pool (SP) market and with standardized contracts in the to-be-announced (TBA) market. We find that this unique parallel trading environment significantly affects MBS returns: (1) Greater heterogeneity in MBS values increases the yields of all MBS, because it exacerbates the cheapest-to-deliver concerns for TBA buyers and reduces the value of the TBA market as a backup selling venue for SP buyers; (2) high selling pressure amplifies the impact of MBS heterogeneity on MBS yields; and (3) greater MBS heterogeneity dampens trading activities on both the SP and TBA markets but increases the ratio between the two. We provide evidence that these effects differ from the impacts of prepayment risks.