Interest‐Rate Volatility, Basis Risk and Heteroscedasticity in Hedging Mortgages

Abstract

This paper investigates the validity of the OLS regression to estimate the hedge ratio for mortgages (GNMA) and provides alternative methodologies. In particular, this paper is concerned with the variance structure (conditional and unconditional heteroscedasticities) and the misspecification (nonlinearities) of the simple linear regression model for direct as well as cross‐hedging. Using data on spot prices of GNMA and futures prices of GNMAs and T‐bills for the period September 1979 to January 1985, we show that there exists significant heteroscedasticity particularly for cross‐hedging, and nonlinearity between cash and futures prices for direct as well as cross‐hedging. Alternative hedge ratio estimates are provided using the Box‐Cox transformation model and an autoregressive conditional heteroscedastic (ARCH) Model.

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