Fannie Mae Negative Arbitrage Calculator

Negative arbitrage occurs when the price of a mortgage-backed security (MBS) is below its intrinsic value, creating an opportunity to profit from the difference. This calculator helps identify and quantify such opportunities in Fannie Mae's mortgage-backed securities.

What is Negative Arbitrage?

Negative arbitrage in mortgage-backed securities refers to a situation where the market price of a security is lower than its theoretical value based on the underlying mortgages. This discrepancy creates an opportunity to profit by purchasing the security at a discount and selling it at its intrinsic value.

Fannie Mae, a government-sponsored enterprise, plays a significant role in the secondary mortgage market. When the market price of Fannie Mae securities falls below their calculated value, it presents an arbitrage opportunity for investors.

How to Calculate Negative Arbitrage

The calculation involves comparing the market price of a security to its intrinsic value. The intrinsic value is determined by the expected cash flows from the underlying mortgages, discounted at an appropriate rate.

Formula

Negative Arbitrage = Market Price - Intrinsic Value

Intrinsic Value = Present Value of Expected Cash Flows

Present Value = Σ [Cash Flow / (1 + Discount Rate)^t]

Where:

Market Price - Current price of the security
Intrinsic Value - Theoretical value based on expected cash flows
Cash Flow - Expected payments from the underlying mortgages
Discount Rate - Appropriate interest rate for the security
t - Time period

Example Calculation

Consider a Fannie Mae security with the following characteristics:

Parameter	Value
Market Price	$105
Expected Cash Flows	$100 (Year 1), $100 (Year 2), $100 (Year 3)
Discount Rate	5%

Calculating the intrinsic value:

Intrinsic Value = $100/(1.05) + $100/(1.05)^2 + $100/(1.05)^3

= $95.24 + $90.70 + $86.45 = $272.39

Negative Arbitrage = Market Price - Intrinsic Value = $105 - $272.39 = -$167.39

This negative value indicates the security is trading at a discount to its intrinsic value, presenting an arbitrage opportunity.

Strategies for Exploiting Negative Arbitrage

When negative arbitrage is identified, investors can implement several strategies:

Direct Purchase: Buy the security at the discounted price and hold until the market price recovers.
Leveraged Purchase: Use borrowed funds to increase the position size and amplify potential profits.
Hedging: Implement hedging strategies to protect against interest rate changes.
Secondary Market Trading: Trade the security in the secondary market to exploit price discrepancies.

Always consider transaction costs, liquidity, and regulatory requirements when executing arbitrage strategies.

Limitations and Considerations

While negative arbitrage presents opportunities, there are several limitations to consider:

Market Liquidity: Some securities may have limited liquidity, making it difficult to execute trades.
Interest Rate Risk: Changes in interest rates can affect the intrinsic value of securities.
Transaction Costs: Brokerage fees and other costs can erode potential profits.
Regulatory Environment: Compliance with securities regulations is essential.

Frequently Asked Questions

What is the difference between positive and negative arbitrage?: Positive arbitrage occurs when a security trades above its intrinsic value, while negative arbitrage occurs when it trades below. Negative arbitrage presents opportunities to profit from the price difference.
How often does negative arbitrage occur in Fannie Mae securities?: Negative arbitrage can occur periodically, especially during market stress or when there are discrepancies between market prices and fundamental values.
What are the risks associated with arbitrage strategies?: Risks include market risk, liquidity risk, and the potential for losses if the market price does not recover as expected.
How can I verify the intrinsic value of a security?: Intrinsic value can be calculated using discounted cash flow models, comparing it to similar securities, or using market-based valuation methods.
Are there any legal considerations for arbitrage trading?: Yes, arbitrage trading must comply with securities regulations and may require registration with regulatory authorities.