What motivates a subprime borrower to default?
AbstractThis paper uses a real options approach to analyse the exercise of the default option embedded in mortgages. In particular, it examines a subprime household who borrows at a premium, but hopes to refinance at prime rates if their house appreciates. We show how these optimal default decisions can be used to calculate probabilities of default - an important input for risk management and pricing purposes. Numerical examples are provided, calibrated to US data. In a low interest rate environment, the credit-upgrade potential may discourage subprime borrowers from defaulting. However, default probabilities are highly sensitive to changes in interest rates and house prices. This provides a rational explanation for the prevalence of adjustable rate mortgages among subprime borrowers, and the subsequent large numbers of defaults, when interest rates rose and house prices declined.
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Bibliographic InfoArticle provided by Elsevier in its journal Journal of Banking & Finance.
Volume (Year): 33 (2009)
Issue (Month): 4 (April)
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Web page: http://www.elsevier.com/locate/jbf
Mortgages Real options Default risk;
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