Improving Parametric Mortgage Prepayment Models with Non-Parametric Kernel Regression
30 Pages Posted: 16 May 2007
Developing a good prepayment model is a central task in the valuation of mortgages and mortgage-backed securities but conventional parametric models often have bad out-of-sample predictive ability. A likely explanation is the highly non-linear nature of the prepayment function. Non-parametric techniques are much better at detecting non-linearity and multivariate interaction. This article discusses how non-parametric kernel regression may be applied to loan level event histories to produce a better parametric model. By utilizing a parsimonious specification, a model can be produced that practitioners can use in valuation routines based on Monte Carlo interest rate simulation.
Keywords: prepayment, valuation, mortgages, non-parametric
JEL Classification: R51
Suggested Citation: Suggested Citation