Crashes in Bond Markets and the Hedging of Mortgage-Backed Securities

Abstract

In Summer 2003 the U.S. bond market saw significant movements of prices that by far exceeded changes in the underlying economic conditions. According to market commentators, the reason was hedging activities in mortgage-backed securities. A simple model shows how this hedging activity can cause crashes in the bond markets, and so is able to explain the observed developments. Some general properties of the model are broadly consistent with the data, thus confirming the importance of hedging mortgage-backed securities for price developments in bond markets.