Optimal Mortgage Loan Diversification

Wharton Financial Institutions Center Working Paper No. 08-12

24 Pages Posted: 17 Mar 2008 Last revised: 28 Mar 2013

See all articles by Kourosh Marjani Rasmussen

Kourosh Marjani Rasmussen

Technical University of Denmark

Stavros A. Zenios

University of Cyprus; Bruegel; University of Pennsylvania - Wharton Financial Institutions Center

Date Written: March 1, 2008

Abstract

Homebuyers in several countries may finance the purchase of their properties using different variants of either adjustable-rate mortgages (ARMs) or fixed-rate mortgages (FRMs). The variety and complexity of these loan products poses a risk management task for mortgage bank advisors to recommend the right mortgage loan strategy for the individual mortgagor; almost all mortgage banks advise their customers to take a single loan product. This argument is often justified by the fact that trade frictions make it unattractive to hold a portfolio of loans as a private home owner. Even with transaction costs, however, we show in this paper that most mortgagors with some degree of risk aversion benefit from holding a mortgage portfolio. To do so we develop a multistage Mean-Conditional Value at Risk (MCVaR) model to consider the risk of the mortgage payment frequency function explicitly using a coherent risk measure. In addition to the diversification benefits we also show that the multistage model produces superior results as compared to single period models and that the solutions are robust with regards to changes in uncertainty parameters in particular for risk averse mortgagors. Finally, we show how the model can be used to calculate fair premia for adjustable rate mortgages with interest rate guarantees (caps) which are becoming increasingly popular as a hybrid product between the existing ARM and FRM mortgages.

Keywords: Mortgage loans products, CVaR modeling, stochastic programming

JEL Classification: C61, D81, E47, G11, G21

Suggested Citation

Rasmussen, Kourosh Marjani and Zenios, Stavros A., Optimal Mortgage Loan Diversification (March 1, 2008). Wharton Financial Institutions Center Working Paper No. 08-12, Available at SSRN: https://ssrn.com/abstract=1106105 or http://dx.doi.org/10.2139/ssrn.1106105

Kourosh Marjani Rasmussen (Contact Author)

Technical University of Denmark ( email )

Anker Engelunds Vej 1
Building 101A
Lyngby, 2800
Denmark

Stavros A. Zenios

University of Cyprus ( email )

75 Kallipoleos Street
P.O. Box 20537
Nicosia CY-1678
Cyprus
+357 2 893605 (Phone)

HOME PAGE: http://https://www.researchgate.net/profile/Stavros_Zenios

Bruegel ( email )

Rue de la Charité 33
B-1210 Brussels Belgium, 1210
Belgium

University of Pennsylvania - Wharton Financial Institutions Center ( email )

3733 Spruce Street
Philadelphia, PA 19104-6374
United States

HOME PAGE: http://zenios.wordpress.com

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