The Effect of Mortgage Price and Default Risk on Mortgage Spreads

Posted: 22 Oct 2005

See all articles by James B. Kau

James B. Kau

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

Luke C. Peters

Bank of America

Abstract

Variations over time in mortgage yield spreads should reflect changes in the underlying prepayment option value; moreover, the relationship between mortgage yield spreads and interest rate dynamics should weaken as the value of the borrower's prepayment option declines. We verify this hypothesis through an empirical analysis of residential mortgage yield spread behavior, and we also present evidence that the strength of the relationship between mortgage spreads and interest rate dynamics weakens (strengthens) as the level of default risk increases (decreases). This result is consistent with the competing risks effect between a borrower's option to prepay or default. Our results demonstrate the importance of accounting for mortgage price discount to par as well as default risk when developing time series of mortgage yields.

Keywords: Mortgage spreads, call option, points, yield curve dynamics

Suggested Citation

Kau, James B. and Peters, Luke C., The Effect of Mortgage Price and Default Risk on Mortgage Spreads. Journal of Real Estate Finance and Economics, Vol. 30, No. 3, 2005, Available at SSRN: https://ssrn.com/abstract=822425

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)

Luke C. Peters

Bank of America ( email )

9 West 57th Street
6th Floor
New York, NY 10019
United States

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