Note: Price of Risk is equal to the annualized excess return demanded for bearing 1% of price volatility due to risk.

When rates dropped to their 40-yr record lows (May-June 2003), refinancing fears reached the stage of panic. High premiums (FNCL7.5 and FNCL8.0) did not appreciate, indicating that their Libor OAS levels increased to 100 bps and above to absorb much of the rate plunge. Calibrated price of refinancing risk surged over those months. No concern about turnover was observed in the calibration, as the discount sector had evaporated.

When rates sharply rose through summer of 2003, the refinancing wave started to cool off; large volumes of freshly originated FNCL4.5 and FNCL5.0 became discounts. In this period, the turnover concerns became apparent. During the rest of the time, we witnessed a general stabilization of the risk prices.

Comparing the heights of purple and blue bars in Figure 1, one can draw the mistaken impression that the MBS market is systematically dominated by the refinancing, not the turnover, fear. In fact, >>>