Valuing Fixed Rate Mortgage Loans with Default and Prepayment Options

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.