Pricing Agency Mortgage Backed Securities Under Quadratic Gaussian Models

Interest rate modeling is an integral part of the mortgage backed security (MBS) pricing mechanism. The particular model choice can have a significant impact on both the MBS valuation and its risk metrics. The market implied interest rate volatility skew suggests that the interest rate distribution is often more normal than log-normal. A normal model tends to shorten the MBS durations while a log-normal model prevents the rates from going negative. We show how QGM models can have the best of both worlds