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Valuing the Mortgage Borrower's Prepayment Option

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  • Arden R. Hall

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.

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  • Arden R. Hall, 1985. "Valuing the Mortgage Borrower's Prepayment Option," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 13(3), pages 229-247, September.
    • Handle: RePEc:bla:reesec:v:13:y:1985:i:3:p:229-247
    DOI: 10.1111/1540-6229.00352
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    Cited by:

    1. Andrew H. Chen & David C. Ling, 1989. "Optimal Mortgage Refinancing with Stochastic Interest Rates," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 17(3), pages 278-299, September.
    2. Ghoddusi, Hamed & Afkhami, Mohamad, 2019. "Valuation of mortgage interest deductibility under uncertainty: An option pricing approach," Journal of Economic Dynamics and Control, Elsevier, vol. 103(C), pages 102-122.
    3. Patric H. Hendershott, 1986. "Mortgage Pricing: What Have We Learned So Far?," NBER Working Papers 1959, National Bureau of Economic Research, Inc.
    4. Ebrahim, M. Shahid, 2009. "Can an Islamic model of housing finance cooperative elevate the economic status of the underprivileged?," Journal of Economic Behavior & Organization, Elsevier, vol. 72(3), pages 864-883, December.
    5. Austin Kelly, 1994. "Capitalization of Above Market Financing - or, A Tale of 2 Condos," Urban/Regional 9412001, University Library of Munich, Germany, revised 24 Dec 1994.
    6. 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.
    7. Werner Hürlimann, 2012. "Valuation of fixed and variable rate mortgages: binomial tree versus analytical approximations," Decisions in Economics and Finance, Springer;Associazione per la Matematica, vol. 35(2), pages 171-202, November.
    8. Austin Kelly, 1998. "Capitalization of Above Market Financing: Condos and Co-ops," Journal of Real Estate Research, American Real Estate Society, vol. 15(2), pages 163-176.
    9. Mahan Tahvildari, 2021. "Forward indifference valuation and hedging of basis risk under partial information," Papers 2101.00251, arXiv.org.
    10. Lim, Terence & Lo, Andrew W. & Merton, Robert C. & Scholes, Myron S., 2006. "The Derivatives Sourcebook," Foundations and Trends(R) in Finance, now publishers, vol. 1(5–6), pages 365-572, April.

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