Default and Prepayment Modelling in Participating Mortgages
30 Pages Posted: 9 Jun 2014 Last revised: 28 Dec 2015
Date Written: December 27, 2015
Since the 2007 financial crisis, the mortgage market has been renovating its tools and instruments in order to avoid a new crisis. One such innovative instrument is the participating mortgage, in which the lender gains part of the net operating income and/or future appreciation. In this paper, we establish a financing model for participating mortgages, incorporating early termination options such as default and two prepayment clauses, defeasance and prepayment penalty. Later, we illustrate a detailed sensitivity analysis and get practical results. The values of early termination options depend on the choice of parameters in the model, as well as the term structure of short term rates. Finally, we show that a participation rate of 11.24% results in zero mortgage interest rate using the parameters in our simulation.
Keywords: Participating mortgages, credit risk, prepayment risk
JEL Classification: G21, G32, R30
Suggested Citation: Suggested Citation