The Causal Effect of Mortgage Refinancing on Interest Rate Volatility: Empirical Evidence and Theoretical Implications

This article investigates the effects of mortgage-backed security (MBS) hedging activity on interest rate volatility and proposes a model that takes these effects into account. An empirical examination suggests that the inclusion of information about MBSs considerably improves model performance in pricing interest rate options and in forecasting future interest rate volatility. The empirical results are consistent with the hypothesis that MBS hedging affects the interest rate volatility implied by both options and the actual interest rate volatility. The results also indicate that the inclusion of information about the MBS universe may result in models that better describe the price of fixed-income securities. The Author 2007. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please email: journals.permissions@oxfordjournals.org, Oxford University Press.