IDEAS home Printed from https://ideas.repec.org/a/bla/reesec/v23y1995i1p1-20.html
   My bibliography  Save this article

An Arbitrage-Free Estimate of Prepayment Option Prices in Fixed-Rate GNMA Mortgage-Backed Securities

Author

Listed:
  • Ehud I. Ronn
  • Peter D. Rubinstein
  • Fung-Shine Pan

Abstract

In an efficient market, the no-arbitrage condition implies that the price difference between any two assets must be the market value of all differences in their cash flows. We use this logic to deduce the price of the prepayment option embedded in fixed-rate Government National Mortgage Association (GNMA) mortgage-backed securities. The option price equals the difference between an observed GNMA price and the cost of a synthetic, nonprepayable GNMA constructed from the least expensive portfolio of Treasury securities that exactly replicates the promised GNMA cash flow stream, assuming prepayment is precluded. We regress the option prices on variables found significant in previous prepayment studies, finding that five key regressors explain more than 90% of the prepayment option value in pooled time-series cross-sectional analysis. We also show that the time value of the prepayment option calculated by our method displays a pattern similar to that produced by the Black-Scholes (1973) option pricing model. An additional empirical result is the existence of negative option prices and negative time value of the option prices. We attribute these to the fact that homeowners sometimes exercise their prepayment options when they are out-of-the-money, and to refinancing transaction costs. Our method is independent of assumptions regarding interest rate processes and the homeowner's prepayment behavior, and it provides a benchmark for testing theoretical prepayment models. Copyright American Real Estate and Urban Economics Association.

Suggested Citation

  • Ehud I. Ronn & Peter D. Rubinstein & Fung-Shine Pan, 1995. "An Arbitrage-Free Estimate of Prepayment Option Prices in Fixed-Rate GNMA Mortgage-Backed Securities," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 23(1), pages 1-20.
  • Handle: RePEc:bla:reesec:v:23:y:1995:i:1:p:1-20
    as

    Download full text from publisher

    File URL: http://www.blackwell-synergy.com/doi/abs/10.1111/1540-6229.00655
    File Function: link to full text
    Download Restriction: Access to full text is restricted to subscribers.

    As the access to this document is restricted, you may want to search for a different version of it.

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. 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.

    More about this item

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:bla:reesec:v:23:y:1995:i:1:p:1-20. See general information about how to correct material in RePEc.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Wiley-Blackwell Digital Licensing) or (Christopher F. Baum). General contact details of provider: http://edirc.repec.org/data/areueea.html .

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    We have no references for this item. You can help adding them by using this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service hosted by the Research Division of the Federal Reserve Bank of St. Louis . RePEc uses bibliographic data supplied by the respective publishers.