Last week, prepayment-model specialists Andrew Davidson & Co. released an industry study that said the better predictor of the mortgage current coupon yield, which is the refinancing rate that borrowers face, is the swaps market and not the Treasuries market.
"There's been a lot of movement in the last few years away from the use of Treasuries towards the use of the swap markets to value fixed-income instruments like mortgages," said Andrew Davidson, president of the Andrew Davidson & Co. "What's significant about this study is not just that it talks about that subject but that it helps quantify an approach for dealing with the need to relate the Treasury yield curve or the swaps curve to mortgage prepayments."
The analysis deals with the effect of interest rate changes on prepayments through the generation of the mortgage current coupon yield and found that the swaps market is a better determinant of the mortgage current coupon yield.
The study also establishes the relationship between mortgage rates and swap rates through complex statistical analysis using serial auto co-relation. In this analysis, the accuracy of the current month's prediction is dependent on the accuracy of last month's prediction.
People could also use this to help them hedge their prepayment risk, Davidson said.
What this analysis concludes is that hedging strategies using the LIBOR curve as a benchmark will be more effective than strategies based on the Treasury curve. The other thing it does is help people better understand the factors that influence one of the key drivers of prepayments - interest rates.