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Valuing Fixed Rate Mortgage Loans with Default and Prepayment Options

Robert M. Dunsky and Thomas S.Y. Ho
The Journal of Fixed Income Spring 2007, 16 (4) 7-31; DOI: https://doi.org/10.3905/jfi.2007.683315
Robert M. Dunsky
Principal financial engineer & economist at OFHEO in Washington, D.C.
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  • For correspondence: robert.dunsky@ofheo.gov
Thomas S.Y. Ho
President of Thomas Ho Company, Ltd in New York, NY.
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  • For correspondence: tom.ho@thomasho.com
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Abstract

There are three integral components to value a fixed rate mortgage loan: 1) the mortgagors' American straddle option on the underling loan, (a call option to refinance and a put option to default); 2) the mortgagors' heterogeneous behavior in exercising the options inefficiently; and 3) the market price of risk, [the option adjusted spread (OAS)]. Despite the dominance of mortgages in the capital market, scant research considers the valuation of mortgage loans while taking these three components into consideration, a contribution of this article. Specifically, this article uses a multinomial logit model to describe the mortgagors' behavior in dealing with the competing refinancing and default risks, and then utilizes a two factor arbitrage-free interest rate model to value the mortgages.

TOPICS: Fixed income and structured finance, options, simulations

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The Journal of Fixed Income
Vol. 16, Issue 4
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Valuing Fixed Rate Mortgage Loans with Default and Prepayment Options
Robert M. Dunsky, Thomas S.Y. Ho
The Journal of Fixed Income Mar 2007, 16 (4) 7-31; DOI: 10.3905/jfi.2007.683315

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Valuing Fixed Rate Mortgage Loans with Default and Prepayment Options
Robert M. Dunsky, Thomas S.Y. Ho
The Journal of Fixed Income Mar 2007, 16 (4) 7-31; DOI: 10.3905/jfi.2007.683315
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