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The Journal of Fixed Income

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Prepayment Option and the Interest Rate Differential
Between a Fixed- and Floating-Rate Mortgage Loan

Jyh-Bang Jou and Tan (Charlene) Lee
The Journal of Fixed Income Spring 2016, 25 (4) 83-91; DOI: https://doi.org/10.3905/jfi.2016.25.4.083
Jyh-Bang Jou
is a professor at the Graduate Institute of National Development at the National Taiwan University in Taipei, Taiwan.
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  • For correspondence: jbjou@ntu.edu.tw
Tan (Charlene) Lee
is a professor in the Department of Finance at the National Central University in Taoyuan City, Taiwan.
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  • For correspondence: charlene@ncu.edu.tw
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Abstract

A fixed-rate borrower has the option to pay off the loan after paying certain penalties. The borrower will do so only if the spot interest rate falls sufficiently below the contract rate. Assuming that the spot interest rate follows a mean-reverting process, this article finds that the fixed-rate borrower has a more valuable prepayment option such that the interest rate differential between a fixed- and a floating-rate loan expands when the term of the loan lasts longer, either the steady-state or initial spot interest rate is lower, penalties associated with prepayment are lower, or interest rates increase at an unpredictable rate.

TOPICS: Fixed income and structured finance, options

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The Journal of Fixed Income: 25 (4)
The Journal of Fixed Income
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Spring 2016
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Prepayment Option and the Interest Rate Differential
Between a Fixed- and Floating-Rate Mortgage Loan
Jyh-Bang Jou, Tan (Charlene) Lee
The Journal of Fixed Income Mar 2016, 25 (4) 83-91; DOI: 10.3905/jfi.2016.25.4.083

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Prepayment Option and the Interest Rate Differential
Between a Fixed- and Floating-Rate Mortgage Loan
Jyh-Bang Jou, Tan (Charlene) Lee
The Journal of Fixed Income Mar 2016, 25 (4) 83-91; DOI: 10.3905/jfi.2016.25.4.083
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