A Generalized Valuation Model for Fixed-Rate Residential Mortgages

This paper uses option pricing techniques to rationally price mortgage instruments subject to both default and prepayment risk. Attention is given to terminations due to purely financial consideration of the mortgage itself, as well as to personally induced terminations. Explicit inclusion of defaul...

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Bibliographic Details
Published in:Journal of money, credit and banking credit and banking, 1992-08, Vol.24 (3), p.279-299
Main Authors: Kau, James B., Keenan, Donald C., Muller, Walter J., Epperson, James F.
Format: Article
Language:English
Subjects:
Banking industry
Contract rates
Contracts
Default
Default insurance
Deferred expenses
Economic models
Fixed rates
Insurance rates
Interest rates
Lenders
Loan defaults
Loan payments
Mathematical models
Mortgage insurance
Mortgage loans
Mortgages
Partial differential equations
Prepayments
Theory
Valuation
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Summary:This paper uses option pricing techniques to rationally price mortgage instruments subject to both default and prepayment risk. Attention is given to terminations due to purely financial consideration of the mortgage itself, as well as to personally induced terminations. Explicit inclusion of default in the mortgage valuation procedure also permits the valuation of insurance against such default. Qualitatively, it is found that default differs significantly in behavior from either prepayment or nonfinancial termination. Quantitatively, however, there is significant substitution between prepayment and default, so that the addition of a default feature to the contract has only a modest impact on mortgage values, unless there is substantial price volatility in the housing market or a high loan-to-value ration. (Printed by permission of the publisher.)
ISSN:0022-2879
1538-4616
DOI:10.2307/1992718