Mortgage Prepayment with an Uncertain Holding Period

J. OF REAL ESTATE FINANCE AND ECONOMICS, Vol. 12 No. 2

Posted: 16 Jun 1998

See all articles by Tyler T. Yang

Tyler T. Yang

Federal Home Loan Mortgage Corporation (FHLMC) - Portfolio Management

Brian A. Maris

Northern Arizona University - College of Business Administration

Abstract

A discrete time option pricing model is developed to value a mortgage and its embedded prepayment option when the effective life of the mortgage is a random variable with a probability distribution of known parameters. The model can be applied when the borrower's ex ante expectation of his tenure follows any probability distribution bounded to the left at zero. The Gamma distribution is used to illustrate the model. The pricing model is further applied to determine the conditions in which financially motivated prepayment is optimal. The results show that the certainty model understates the Interest Rate Differential needed to justify prepayment (IRD) for short Expected Holding Period (EHP) borrowers and overstates the IRD for long EHP borrowers. When the EHP is relatively long, the certainty model provides relatively good estimates of IRD during the beginning years of the mortgage life. Under most other conditions, the estimates of the certainty holding period model are biased.

JEL Classification: R0

Suggested Citation

Yang, Tyler T. and Maris, Brian A., Mortgage Prepayment with an Uncertain Holding Period. J. OF REAL ESTATE FINANCE AND ECONOMICS, Vol. 12 No. 2. Available at SSRN: https://ssrn.com/abstract=9091

Tyler T. Yang (Contact Author)

Federal Home Loan Mortgage Corporation (FHLMC) - Portfolio Management ( email )

McLean, VA 22101
United States

Brian A. Maris

Northern Arizona University - College of Business Administration ( email )

PO Box 15066
Flagstaff, AZ 86011
United States

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