Staff Reports
Cash-Forward Arbitrage and Dealer Capital in MBS Markets: COVID-19 and Beyond
Number 933
July 2020 Revised September 2020

JEL classification: G12, G14, G18

Authors: Jiakai Chen, Haoyang Liu, Asani Sarkar, and Zhaogang Song

We examine the economic mechanisms that limited arbitrage between the cash and forward markets of agency MBS, and whether asset purchases of the Federal Reserve (Fed) alleviated price dislocations. We find that the cash-forward basis, or the price difference between the cash and forward markets of agency MBS controlling for differences in fundamentals, widened significantly by $0.9 per $100 face value during the height of the COVID-19 crisis. The widening basis was accompanied by a significant increase in selling by customers in the cash market, indicating a “scramble-for-cash” following the liquidity shock. Dealers provided liquidity by increasing both their long cash and short forward positions significantly but the basis continued to widen, implying that balance sheet costs constrained dealers’ inventories. We estimate dealers’ average costs of holding inventory for five weeks as about $0.8. We also find that primary dealers affiliated with banks subject to Basel III liquidity regulations increased their positions more than others. The basis narrowed by about $0.7 following the Fed’s MBS purchases in the forward market. We attribute this effect to the faster settlement schedules of the Fed’s purchases, compared to the market convention, which allowed a faster deployment of capital. Overall, our results show that the combined liquidity constraints of investors and dealers led to severe price dislocations, and the Fed, in its role as the “dealer of last resort,” absorbed the liquidity demand that dealers lacked the capacity to meet.

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AUTHOR DISCLOSURE STATEMENT(S)
Jiakai Chen
I, Jiakai Chen, declare that I have no relevant or material financial interests that relate to the research described in the paper titled “Cash-Forward Arbitrage and Dealer Capital in the MBS Markets: COVID-19 and Beyond,” co-authored with Haoyang Liu, Asani Sarkar, and Zhaogang Song. Prior to circulation, this paper was reviewed in accordance with the Federal Reserve Bank of New York review policy, available at https://www.newyorkfed.org/research/staff_reports/index.html.

Haoyang Liu
The author declares that he has no relevant or material financial interests that relate to the research described in this paper. Prior to circulation, this paper was reviewed in accordance with the Federal Reserve Bank of New York review policy, available at https://www.newyorkfed.org/research/staff_reports/index.html.

Asani Sarkar
The author declares that (s)he has no relevant or material financial interests that relate to the research described in this paper. Prior to circulation, this paper was reviewed in accordance with the Federal Reserve Bank of New York review policy, available at https://www.newyorkfed.org/research/staff_reports/index.html.

Zhaogang Song
The author declares that he has no relevant or material financial interests that relate to the research described in this paper.
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