Transaction Costs, Suboptimal Termination and Default Probabilities

Abstract

The same option‐based methodology now commonly used to value mortgages and their termination features also can be applied to calculate the probabilities that mortgage default will occur. This paper pursues that idea, and furthermore, enriches the idealized option‐based approach by introducing both transaction costs and “suboptimal” termination. These latter features capture the individual considerations that cause a mortgage holder's actions to differ from what rationality would indicate based solely on the market value of the mortgage. These features are of considerable importance if the results of options‐based models are to be made comparable to those calculations of default probabilities occurring in the empirical literature.