Determining the efficiency of the GNMA mortgage-backed securities market

This paper is an evaluation of the efficiency of the Government National Mortgage Association (GNMA) mortgage-backed securities market. GNMA securities represent a $702 billion market. Despite this size, the securities do not trade on an organized exchange. Trading on an organized exchange implies that a maximum amount of available information is incorporated into prices. Consequently, can the GNMA market be efficient?

An efficient market, as posited by Eugene Fama and others, is one where all of the information available in a market is incorporated in the prices in that market. There are various levels of efficiency ranging from the use of all publicly available information to the use of that information plus information not generally available (i.e. proprietary and "insider" information".) This paper considers the more general case of information available in period t not being used in that period but rather being incorporated in the prices of period t+n.

The analysis uses monte carlo simulation to generate paths of discount rates based on the yield curve for U.S. Treasury securities. These periodic rates along with a common spread are used to discount the estimated cash flows on the GNMA securities. The common spread is termed the Option Adjusted Spread ("OAS") and is postulated to incorporate all of the market information over and above that is used in setting prices (and their corollary, yields) in the Treasury market.

The test of market efficiency is whether or not the prices in period t are correlated with the OAS of a subsequent period.