UK Fixed Rate Repayment Mortgage and Mortgage Indemnity Valuation

Abstract

We use a mean‐reverting interest rate model and a lognormal house price diffusion model to evaluate British fixed rate repayment mortgage contracts with (embedded) default and prepayment options. The model also provides values for capped mortgage indemnity guarantees and the corresponding (residual) lender’s coinsurance. Since the partial differential equation incorporating the general features of these mortgage contracts does not have a closed‐form solution, an explicit finite difference method is used for the valuation (and sensitivity) results, with solution improvements to deal with error bounds. Then we provide graphical representations of each mortgage component as a function of house prices and interest rate levels, along with interpretations of the analysis. We calculate precisely the lender’s (residual) exposure to house price risk, given the borrower’s options, house and interest rate uncertainty, and customary mortgage indemnity insurance for high loan/collateral ratio mortgages.