Frictions and Mortgage Options
30 Pages Posted: 18 Nov 1999
Mortgage researchers developing numerous hypotheses concerning the most relevant factors for mortgage valuation, have generated a wealth of recent ideas. Each new hypothesis generates an additional separate empirical test. This paper combines many features of recent mortgage models into a single options theoretic model for valuing the mortgage liability to the borrower and the mortgage asset to the investor. The two values are the same in a frictionless world. However, the values differ with the addition of frictions such as transaction costs, suboptimal termination, and decision probabilities (a likelihood that the borrower will make a decision). The model in this paper is used to evaluate numerous frictions, either individually or simultaneously. The mortgage pricing model in this paper is useful for exploring the separate or simultaneous effects on mortgage values of both fixed and variable transaction costs associated with borrower prepayment and default, all within an options theoretic framework. For example, transaction costs of defaulting may be hypothesized as higher for larger families (higher moving costs) than smaller families. Additionally, there may be fixed transaction costs of defaulting that are associated with credit rating, regardless of the family size.
JEL Classification: G12, G21
Suggested Citation: Suggested Citation