A Generalized Valuation Model for Fixed-Rate Residential Mortgages

• Published in: Journal of money, credit and banking Vol. 24; no. 3; pp. 279 - 299
• Main Authors: Kau, James B., Keenan, Donald C., Muller, Walter J., Epperson, James F.
• Format: Journal Article
• Language: English
• Published: Columbus Ohio State University Press 01.08.1992; John Wiley & Sons, Inc
• 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; United States > US
• ISSN: 0022-2879; 1538-4616
• DOI: 10.2307/1992718

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.)