The Valuation at Origination of Fixed Rate Mortgages with Default and Prepayment
THE JOURNAL OF REAL ESTATE FINANCE AND ECONOMICS, Vol 11
Posted: 25 Aug 1998
This paper develops a model to rationally price fixed rate mortgages, using the arbitrage principles of option pricing theory. The paper incorporates amortization, prepayment and default in valuing the mortgage. Having completely specified the model, numerical procedures value the different features of the mortgage contract under a variety of economic conditions. The necessity of having both the interest rate and the house price as explanatory variables, due to the interaction of default and prepayment, is demonstrated. The numerical solutions presented center around mortgage pricing at origination. Thus, variations in the equilibrium contract rate are examined for differing economic conditions and changes in the contract. Finally, by presenting a complete model, the paper yields insights for the existence of common institutional practices.
JEL Classification: G12, G21
Suggested Citation: Suggested Citation