Analyses of Mortgage-Backed Securities Based on Unobservable Prepayment Cost Processes

Posted: 24 Dec 2010 Last revised: 11 Jan 2018

See all articles by Hidetoshi Nakagawa

Hidetoshi Nakagawa

Hitotsubashi University Business School

Tomoaki Shouda

Independent

Date Written: December 24, 2010

Abstract

We propose a prepayment model of mortgage based on a structural approach in order to analyze prepayment risk of mortgage-backed securities (MBS). We introduce a continuous process named prepayment cost process. Specifically, each mortgagor's prepayment time is defined by the first time when her or his prepayment cost process falls below zero, but prepayment cost processes are supposed to be unobservable in the market. We also introduce a risk unique to each loan pool of mortgages, called a loan pool risk (LPR), and we regard LPR as a systematic risk other than interest rate. Using the model, we discuss the conditional distribution of prepayment times and a risk-neutral valuation of pass-through MBS. It is shown that each mortgagor's conditional non-prepayment probability and the posterior distribution of LPR play quite important roles in our study.

Keywords: mortgage-backed securities (MBS), prepayment cost, loan pool risk, structural approach with incomplete information, asymptotic arbitrage-free condition

Suggested Citation

Nakagawa, Hidetoshi and Shouda, Tomoaki, Analyses of Mortgage-Backed Securities Based on Unobservable Prepayment Cost Processes (December 24, 2010). Asia-Pacific Financial Markets, Vol. 11, No. 3, pp. 233-266, 2006, Available at SSRN: https://ssrn.com/abstract=1730804

Hidetoshi Nakagawa (Contact Author)

Hitotsubashi University Business School ( email )

National Center for Sciences
2-1-2 Hitotsubashi,
Chiyoda-ku,, 1018439
Japan
342123104 (Phone)

Tomoaki Shouda

Independent ( email )

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