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Valuing the Mortgage Borrower's Prepayment Option

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  • Arden R. Hall
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    Abstract

    This paper investigates the value of the prepayment option that normally accompanies a fixed-rate mortgage. Using the two-state option-pricing model developed by Bartter and Rendleman, the paper presents simulations of prepayment option values using several sets of interest rate parameters. The sensitivity of the value of the option to changes in various aspects of the mortgage contract is assessed. Prepayments are not priced separately in the market from the underlying mortgage, so the paper investigates how the inclusion of a prepayment option affects the contract interest rate. Finally, there is reason to believe that any option-pricing model will overestimate the value of a mortgage prepayment option. The size of this bias is assessed indirectly and is found to be rather small. Copyright American Real Estate and Urban Economics Association.

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    Bibliographic Info

    Article provided by American Real Estate and Urban Economics Association in its journal Real Estate Economics.

    Volume (Year): 13 (1985)
    Issue (Month): 3 ()
    Pages: 229-247

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    Handle: RePEc:bla:reesec:v:13:y:1985:i:3:p:229-247

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    Cited by:
    1. Werner Hürlimann, 2012. "Valuation of fixed and variable rate mortgages: binomial tree versus analytical approximations," Decisions in Economics and Finance, Springer, vol. 35(2), pages 171-202, November.
    2. Patric H. Hendershott & Robert Van Order, 1987. "Pricing Mortgages: An Interpretation of the Models and Results," NBER Working Papers 2290, National Bureau of Economic Research, Inc.
    3. M. Shahid Ebrahim, 2008. "Can an Islamic Model of Housing Finance Cooperative Elevate the Economic Status of the Underprivileged?," Papers on Economics of Religion 08/04, Department of Economic Theory and Economic History of the University of Granada..
    4. Austin Kelly, 1994. "Capitalization of Above Market Financing - or, A Tale of 2 Condos," Urban/Regional 9412001, EconWPA, revised 23 Dec 1994.

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