TY - JOUR T1 - A Fixed-Rate Mortgage Valuation Model in Three State Variables JF - The Journal of Fixed Income SP - 17 LP - 27 DO - 10.3905/jfi.2001.319289 VL - 11 IS - 1 AU - Andrew L. Brunson AU - James B. Kau AU - Donald C. Keenan Y1 - 2001/06/30 UR - https://pm-research.com/content/11/1/17.abstract N2 - 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. ER -