Introduction

Trading Pass-Through Agency Mortgage-Backed Securities (MBS) is a crucial aspect of the mortgage market, facilitating the movement of these securities among investors and market participants. In this chapter, we will delve into the process of trading pass-through agency MBS, understanding the dynamics that drive their trading, and exploring the factors that impact their prices and yields.

Trading Pass-Through Agency MBS

Pass-Through Agency MBS are securities backed by pools of residential mortgages. These securities pass through the principal and interest payments from the underlying mortgage loans to the investors.

Trading in Pass-Through Agency MBS involves buying and selling these securities in the secondary market. Investors can purchase MBS through various channels, including brokers, dealers, and electronic trading platforms. The market for pass-through MBS is highly liquid, with significant trading volume.

Factors Influencing MBS Trading

Several factors influence the trading dynamics of pass-through agency MBS:

• Interest Rates: Changes in interest rates directly impact the trading of MBS. When interest rates rise, MBS prices tend to fall as their yields become less attractive compared to newly issued securities. Conversely, when interest rates decline, MBS prices tend to rise.

• Prepayment Risk: MBS carry prepayment risk, meaning homeowners can refinance or pay off their mortgages early. This uncertainty about the timing and extent of prepayments affects MBS trading. Higher prepayment rates can lead to lower MBS prices.

• Credit Risk: Although agency MBS are considered low credit risk due to government backing, some level of credit risk exists in the underlying mortgages. This risk can influence trading decisions.

• Market Sentiment: Investor sentiment, economic indicators, and geopolitical events can affect trading activity and MBS prices.

Yield and Price Calculations

The yield and price of MBS are interconnected. The yield $(Y)$ can be calculated using the following formula:

$$Y=\frac{\text { Annual Cash Flows }}{\text { Current Market Price }}$$

Where Annual Cash Flows include principal and interest payments. Conversely, the price (P) of an MBS can be calculated using the yield and cash flows:

$$P=\frac{\text { Annual Cash Flows }}{\text { Yield }}$$

Example: Suppose you have an MBS with annual cash flows of USD 1,000 and a yield of 4%. The price of the MBS would be:

$$P = \frac{1000}{0.04} = \text{USD 25,000}$$