A New Prepayment Model (with Default): An Occupation-Time Derivative Approach

Nicholas J. Sharp, Paul V. Johnson, David Newton, Peter W. Duck

Research output: Contribution to journalArticlepeer-review

7 Citations (Scopus)

Abstract

A new prepayment model is developed, which improves the modeling of the borrowers decision process by incorporating an occupation-time derivative in the valuation framework of a fixed-rate mortgage. This option-theoretic mortgage valuation model is based on stochastic house-price and interest-rate models, and requires a particularly subtle technique to incorporate a new type of occupation-time derivative, where the barrier (which activates the derivative) is in the value process and not the underlying process (as it is in standard occupation-time derivatives). This new model simulates a delay in prepayment by the borrower (beyond the time simple ruthless prepayment dictates), thus increasing the value of the mortgage to the lender, compared to the value gained using more basic models. This allows for a more advanced borrower decision process, where a rational exercise structure is retained in a modified form. Empirical evidence supports this theory, which should be beneficial for accurate mortgage-backed security pricing. The results in this paper explore thoroughly the effect on the mortgage value of a delay in prepayment by the borrower on the embedded options held and on the insurance component.
Original languageEnglish
Pages (from-to)118-145
Number of pages28
JournalJournal of Real Estate Finance and Economics
Volume39
Issue number2
Early online date25 Jan 2008
DOIs
Publication statusPublished - 1 Aug 2009

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