Now, after having looked at more trading days, I have found that this TBA-IO dislocation might actually be an exception rather than the rule. Upon request, I could forward charts similar to those shown in the Quantitatve Perspective and in the powerpoint presentation, for these additional market dates and conditions. We are now inclined to state that two market anomalies we found and documented, exaggerated prices of risk in times of panic and the TBA-IO disparity, may, in fact, represent the same phenomenon. Moreover, prices of risk as well as relative prOAS pricing of IOs versus collateral are not as much functions of the rate level, as the rate dynamics. Sharp change in rates destabilizes both TBA and IO markets; when rates get "stuck" to the new level, panic dissipates. Price of risk steadies and is recognized by the market; the TBA-IO arbitrage disappears

Q. Does the arbitrage argument require lognormality of prices and factors?

A. No, it does not. The risky ("derivative") asset can follow any stochastic behavior, but its return should be linear in logarithmic derivative of price with respect to factor of risk (i.e. factor duration). As for the risk factor, it does not have to be normal or lognormal - it can even be a non-traded random variable. For example, prepayment error is not a price of any "underlying" asset.

Q. Prices of risk appear to be time-dependent. Is it a blow to the prOAS theory? Should the market participant recalibrate prices of risk regularly?

A. Let us re-read John Hull's 4th edition of "Options, futures, and other derivatives". He denotes factor of risk as q , time as t, and the value of derivative as f. The market price of risk, Hull asserts on page 500, "may be dependant on both q and t, but it is not dependent on the nature of the derivative f".

All words in this concise statement are worth considering. First, a risk-adjusted valuation model with constant prices of risk is an over-simplification not required by the arbitrage pricing theory. Variability of prices of risk is the rule rather than an exception. However, we believe that exaggerated dynamics, clearly seen in times of panic, present opportunities for successful speculative investment decisions. As for the practical matter, the prOAS model needs a live market feed and must be re-calibrated regularly - in the same way we re-calibrate a term structure model with rates and volatilities changing.

On the other hand, the TBA - IO market disparity, when exists, is a true arbitrage opportunity because prices of risk appear to depend on instruments. And, if the TBA-IO convergence is inevitable, combining IOs and TBAs can be viewed as a hedged speculation. >>>