The Pricing of Default-Free Mortgages

36 Pages Posted: 19 Mar 2001 Last revised: 9 May 2021

See all articles by Stephen A. Buser

Stephen A. Buser

Ohio State University (OSU) - Department of Finance

Patric H. Hendershott

University of Aberdeen - Centre for Property Research; National Bureau of Economic Research (NBER)

Date Written: July 1984

Abstract

In this paperwe examine the household's option to prepay or call a standard fixed-rate mortgage. Results based on simulation indicate that the value of this option is sensitive to the expected path of interest rates, the variation around that path, risk aversion and refinancing costs. Unfortunately, efforts to estimate the interest rate process (by us and by previous authors) have met with only limited success, and uncertainty exists regarding the degree of risk aversion and the magnitude of refinancing costs.Thus we conclude that the application of contingent-claims methodology to options on bonds is conceptually more difficult and operationally less reliable than is the analogous application to options on stocks.Despite these reservations concerning the use of our model as a technique for absolute valuation, preliminary findings on the effects of changes in mortgage contract design on the value of the prepayment option are encouraging. For example, our estimate of the relative values of the call options on 30- and 15-year mortgages and on level-payment and graduated-payment mortgages appear to be reasonably robust with respect to specifications of the interestrate process and the other parameters.These findings suggest that our model may be of considerable use within the context of relative or comparative valuation.

Suggested Citation

Buser, Stephen and Hendershott, Patric H., The Pricing of Default-Free Mortgages (July 1984). NBER Working Paper No. w1408, Available at SSRN: https://ssrn.com/abstract=228036

Stephen Buser (Contact Author)

Ohio State University (OSU) - Department of Finance ( email )

2100 Neil Avenue
Columbus, OH 43210-1144
United States
614-292-5719 (Phone)

Patric H. Hendershott

University of Aberdeen - Centre for Property Research ( email )

Aberdeen AB24 2UF
Scotland

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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