Abstract
This article investigates the effect of a two-factor interest rate process on the value of the mortgage and its inherent options including the right to default. Our complete three-state model for a mortgage derivative asset is used to make comparisons with the standard two-state model with the option to default or prepay. With slight modification, this model is applicable to other types of mortgages and mortgage-backed securities, and to derivative securities in general. The authors demonstrate that a two-state model with a one-factor term structure and a three-state model with a two-factor term structure value a mortgage substantially differently. The results suggest that valuing defaultable mortgages requires a three-state option pricing model to avoid mispricing.
- © 2001 Pageant Media Ltd
Don’t have access? Click here to request a demo
Alternatively, Call a member of the team to discuss membership options
US and Overseas: +1 646-931-9045
UK: 0207 139 1600