Journal of Real Estate Finance and Economics, 7:99-115 (1993) 9 1993 Kluwer Academic Publishers Intermarket Efficiency: An Application of Interbattery APT to Mortgage-Backed Securities EDWARD L. BUBNYS Associate Professor of Finance, Suffolk University, Boston, MA 02108 SHAHRIAR KHAKSARI Professor of Finance, Suffolk University, Boston, MA 02108 MURAT TARIMCILAR Associate Professor of Management, Suffolk University, Boston, MA 02108 Abstract Increasing popularity of investments in mortgage-backedsecurities has led to closer integration of the mortgage market into traditional capital markets. Using monthly returns during 1982-1988 for common stocks, Treasury bonds and GNMA and FHLMC mortgage-backed securities, the interbattery factor analytic Arbitrage Pricing Theory of (Cho, 1984) is used to test five hypotheses for intramarket and intermarket integration. Results indicate that three to five common factors are found within the same security market, while only one to three factors are found common between different markets. The APT could not be rejected within the same security market, but was rejected in most intermarket com- parisons. While risk-free rates are found to differ between markets, the risk premium tests are conclusive in- dicators of integration.Our results support claimsthat the stock, bond, and the mortgage-backed securitiesmarkets are integrated. Key words: Mortgage-backed securities, integration, interbattery factor analysis, Arbitrage Pricing Theory Growth in the secondary mortgage market during the early 1980s increased sources of mort- gage funding to include nontraditional investors (such as insurance companies and pension funds), as well as traditional investors such as local thrifts. This development led to the mortgage market being more closely integrated into the nation's capital markets, thereby increasing capital market efficiency. However, despite the substantial change in the mort- gage market and the significnat empirical research in capital market efficiency, there has not been much study of intermarket efficiency. The question of integration or segmenta- tion of the stock, bond, and mortgage-backed securities (MBS) markets has not received much attention in the finance literature. Segmented markets are usually the result of either informational or institutional bar- riers. They provide arbitrage opportunities for investors who can buy and sell similar-risk securities at significantly different prices. The presence of these markets also has implica- tions for effective diversification of investment portfolios. An example is investment op- portunities in worldwide stock markets. Asset pricing models have been frequently used in tests of market efficiency. The Arbitrage Pricing Theory (APT) (Ross, 1976) provides one model for explaining the relationship