Carl A. Bath*'''
everal developments in the early 1980s brought the general problem of S hedging mortgage-backed securities (MBS) to prominence. Investor demand for these instruments was boosted sharply by legislation designed to improve liquidity in the thrift industry. The new regulations permitted savings institutions to satisfy their housing-related asset requirements by holding MBS-the marketable claims to pools of mortgages packaged by such agencies as GNMA, FNMA, and FHLMC. At the same time, the dramatic increase in interest rate volatility following the adoption of new operating procedures by the Federal Reserve in 1979 provided these large investors with a strong incentive to hedge these assets. Unfortunately, the absence of a liquid futures market in MBS rendered the straightforward approach of hedging MBS holdings with an equal amount of MBS futures contracts infeasible.' *I wish to thank Robert S. Smith, Arthur Warga, and two anonymous referees for helpful comments. +After the completion of this paper, I became aware of an unpublished paper by Frank Jones and Anshuman Jain entitled "Hedging Mortgage-Backed Securities," which makes some of the same points made here.
'There does exist a futures market for GNMA passthrough certificates, but it has become extremely thin and therefore not attractive for hedgers who require a high, reliable correlation between cash and futures prices. Interestingly, the illiquidity of this market stems from the same factor which renders the hedge ratio and hedging effectiveness measure described in this article unstable-namely the existence of a call option implicit in the MBS. While the contract specifications for Treasury bond and note futures require that the underlying cash market instrument have adequate call protection to qualify for delivery, this feature is necessarily absent from GNMA futures, since exercise of the call depends on the level of market interest rates and therefore cannot be legislated. Interest rate declines since 1982 have increased the importance of this call option feature and thus led to the deterioration of liquidity in the GNMA futures market.