Modeling the Mortgage-Treasury Spread

This is a discussion of the fundamentals underlying a proprietary thirty-year conventional perfect current-coupon projection model. This model measures the richness or cheapness of the current-coupon mortgage as a function of the fundamental variables that influence mortgage pricing: the level of rates, the shape of the curve, and volatility. It is designed not to provide an automatic trading rule but rather to serve as a starting point for looking at the mortgage-Treasury spread in a consistent fashion. While the model has a number of limitations, a performance study using two different consistent trading rules finds quite favorable results: the model performed well in 1993, 1994, and 1995