Valuing Prepayment and Default in a Fixed Rate Mortgage: A Bivariate Binomial Options Pricing Technique

Posted: 3 Nov 1998

See all articles by Jimmy E. Hilliard

Jimmy E. Hilliard

Louisiana State University, Baton Rouge - E.J. Ourso College of Business Administration

James B. Kau

University of Georgia - Department of Insurance, Legal Studies, Real Estate

V. Carlos Slawson, Jr.

Louisiana State University

Abstract

This paper uses a bivariate binomial options pricing technique to value the prepayment and default options in a fixed-rate mortgage. The American style options are dependent on two stochastic variables: (1) house price, (2) one year spot rate. The paper uses the standard lognormal process for house price and the CIR square-root process for interest rates. By forcing the two underlying state variables to undergo transformations, two new uncorrelated variables with constant volatilities are established. With constant volatilities, a computationally simple bivariate binomial tree is formed which greatly reduces the complexity of working with two state variables and is pedagogicallyuseful. Using this procedure, the price of any real estate contingent claim whose value is dependent on the one year spot rate and house price can be determined. Results are compared with those from a finite difference model.

JEL Classification: G12

Suggested Citation

Hilliard, Jimmy E. and Kau, James B. and Slawson, Jr., V. Carlos, Valuing Prepayment and Default in a Fixed Rate Mortgage: A Bivariate Binomial Options Pricing Technique. Available at SSRN: https://ssrn.com/abstract=6107

Jimmy E. Hilliard

Louisiana State University, Baton Rouge - E.J. Ourso College of Business Administration ( email )

Department of Finance
Baton Rouge, LA 70803-6308
United States
225-578-7676 (Phone)
225-578-6366 (Fax)

James B. Kau (Contact Author)

University of Georgia - Department of Insurance, Legal Studies, Real Estate ( email )

Athens, GA 30602-6254
United States
706-542-9110 (Phone)
706-542-4295 (Fax)

V. Carlos Slawson, Jr.

Louisiana State University ( email )

E. J. Ourso College of Business
Department of Finance
Baton Rouge, LA 70803-6308
United States
225-578-6291 (Phone)

HOME PAGE: http://www.lsu.edu/business/finance/profile-viewer.php?un=cslawson

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