A Generalized Valuation Model for Fixed-Rate Residential Mortgages

TLDR

The paper applies option‑pricing methods to value residential mortgages accounting for default and prepayment risk. It models mortgage terminations via option‑pricing, incorporating financial and personal prepayment triggers and default, enabling valuation of default insurance. The study finds that default behaves differently from prepayment or nonfinancial terminations, yet default and prepayment largely substitute for each other, so adding default risk only modestly affects mortgage values unless housing volatility or high loan‑to‑value ratios are present. © 1992 Ohio State University Press.

Abstract

This paper uses option pricing techniques to rationally price mortgage instruments subject to both default and prepayment risk. Attention is given to terminations due to purely financial consideration of the mortgage contract itself, as well as to personally induced terminations. Explicit inclusion of default in the mortgage valuation procedure also permits the valuation of insurance against such default. Qualitatively, it is found that default differs significantly in the behavior from either prepayment or nonfinancial termination. Quantitatively, however, there is significant substitution between prepayment and default, so that the addition of a default feature to the contract has only a modest impact on mortgage values, unless there is substantial price volatility in the housing market or a high loan-to-value ratio. Copyright 1992 by Ohio State University Press.