Optimal Sharing of Interest‐Rate Risk in Mortgage Contracts: The Effects of Potential Prepayment and Default

24 Pages Posted: 3 Aug 2017  

Jan K. Brueckner

University of California, Irvine - Department of Economics; CESifo (Center for Economic Studies and Ifo Institute)

Kangoh Lee

San Diego State University - Department of Economics

Date Written: Autumn 2017

Abstract

Much of the literature on the economics of mortgage markets has studied the fixed vs. adjustable‐rate mortgage choice made by individual borrowers. However, to decide if the outcome of such a choice is efficient or approximately so, it is necessary to explore the question of optimal risk‐sharing in mortgage contracts. But because only a small literature has studied this question, more research is clearly warranted. The present article helps fill this gap by developing a simplified version of Arvan and Brueckner's model, using it to characterize optimal contracts in the absence of mortgage termination, and then exploring how termination via prepayment or default affects optimal risk‐sharing. The broad conclusion of the analysis is that potential mortgage termination makes higher risk exposure for borrowers optimal.

Suggested Citation

Brueckner, Jan K. and Lee, Kangoh, Optimal Sharing of Interest‐Rate Risk in Mortgage Contracts: The Effects of Potential Prepayment and Default (Autumn 2017). Real Estate Economics, Vol. 45, Issue 3, pp. 761-784, 2017. Available at SSRN: https://ssrn.com/abstract=3012879 or http://dx.doi.org/10.1111/1540-6229.12149

Jan K. Brueckner (Contact Author)

University of California, Irvine - Department of Economics ( email )

3151 Social Science Plaza
Irvine, CA 92697-5100
United States

CESifo (Center for Economic Studies and Ifo Institute)

Poschinger Str. 5
Munich, DE-81679
Germany

Kangoh Lee

San Diego State University - Department of Economics ( email )

5500 Campanile Drive
San Diego, CA 92182
United States

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