IDEAS home Printed from
MyIDEAS: Log in (now much improved!) to save this article

Pricing the Default Option of Inflation-Indexed Mortgages Using Explicit Finite Difference Method

Listed author(s):
  • Isil Erol


    (Department of Economics, Middle East Technical University, Ankara-Turkey;)

  • Kanak Patel


    (Department of Land Economy, University of Cambridge, England;)

This paper evaluates the default risk of civil servants’ wage-indexed payment mortgage (WIPM) contract in Turkey, which is linked to the expected inflation. The aim of the study has two sides: one is to apply the contingent claims approach, which has been widely used to price standard fixed- and adjustable-rate contracts, to price an inflation-indexed mortgage. The second is to understand if WIPM contract is a suitable mortgage design for lenders under an inflationary economy. We extend the traditional risk-neutral valuation for pricing the WIPM contract with its embedded default option. Using backward pricing method, namely the explicit finite difference method, we evaluate this unique nflation-indexed mortgage contract from the lender’s point of view. The expected inflation and house price are the two tochastic variables underlying the WIPM contract. Our numerical results show that the lender benefits from originating WIPM only during the periods when the real interest rate is very low. xpected inflation risk premium notably increases the value of future payments on WIPM contract, resulting in high values of lender’s position in the mortgage agreement. The results also show that house price volatility has a greater effect on the borrower’s default option value compared to the expected inflation volatility

If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.

File URL:
File Function: Full text
Download Restriction: no

Article provided by Asian Real Estate Society in its journal International Real Estate Review.

Volume (Year): 10 (2007)
Issue (Month): 1 ()
Pages: 48-92

in new window

Handle: RePEc:ire:issued:v:010:n:01:2007:p:48-92
Contact details of provider: Postal:
Asia Real Estate Society, 51 Monroe Street, Plaza E-6, Rockville, MD 20850, USA

Web page:

Order Information: Postal: Asian Real Estate Society, 51 Monroe Street, Plaza E-6, Rockville, MD 20850, USA
Web: Email:

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:

in new window

  1. William H. Scott & Arthur L. Houston & A. Quang Do, 1993. "Inflation Risk, Payment Tilt, and the Design of Partially Indexed Affordable Mortgages," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 21(1), pages 1-25.
  2. Baesel, Jerome B. & Biger, Nahum, 1980. "The Allocation of Risk: Some Implications of Fixed versus Index-Linked Mortgages," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 15(02), pages 457-468, June.
  3. Peter J. Elmer, 1992. "PLAM Default Risk," Journal of Real Estate Research, American Real Estate Society, vol. 7(2), pages 157-168.
  4. Kearl, J R, 1979. "Inflation, Mortgages, and Housing," Journal of Political Economy, University of Chicago Press, vol. 87(5), pages 1115-1138, October.
  5. José A. Azevedo-Pereira & David P. Newton & Dean A. Paxson, 2002. "UK Fixed Rate Repayment Mortgage and Mortgage Indemnity Valuation," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 30(2), pages 185-211.
  6. James B. Kau & Donald C. Keenan & Walter J. Muller & James F. Epperson, 1990. "The Valuation and Analysis of Adjustable Rate Mortgages," Management Science, INFORMS, vol. 36(12), pages 1417-1431, December.
  7. Stanton, Richard & Wallace, Nancy, 1999. "Anatomy of an ARM: The Interest-Rate Risk of Adjustable-Rate Mortgages," The Journal of Real Estate Finance and Economics, Springer, vol. 19(1), pages 49-67, July.
  8. Taewon Kim, 1987. "A Contingent Claims Analysis of Price Level-Adjusted Mortgages," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 15(3), pages 117-131.
  9. Hakan Berument & Kamuran Malatyali, 1999. "Determinants of interest rates in Turkey," Discussion Papers 9902, Research and Monetary Policy Department, Central Bank of the Republic of Turkey.
  10. Kau, James B, et al, 1993. "Option Theory and Floating-Rate Securities with a Comparison of Adjustable- and Fixed-Rate Mortgages," The Journal of Business, University of Chicago Press, vol. 66(4), pages 595-618, October.
  11. Richard Stanton & Nancy Wallace, 1995. "ARM Wrestling: Valuing Adjustable Rate Mortgages Indexed to the Eleventh District Cost of Funds," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 23(3), pages 311-345.
  12. Ramaswamy, Krishna & Sundaresan, Suresh M., 1986. "The valuation of floating-rate instruments : Theory and evidence," Journal of Financial Economics, Elsevier, vol. 17(2), pages 251-272, December.
  13. Gibson, Rajna & Schwartz, Eduardo S, 1990. " Stochastic Convenience Yield and the Pricing of Oil Contingent Claims," Journal of Finance, American Finance Association, vol. 45(3), pages 959-976, July.
  14. Gerald Buetow, Jr. & Joseph Albert, 1998. "The Pricing of Embedded Options in Real Estate Lease Contracts," Journal of Real Estate Research, American Real Estate Society, vol. 15(3), pages 253-266.
  15. Lea, Michael J. & Bernstein, Steven A., 1996. "Housing Finance in an Inflationary Economy: The Experience of Mexico1," Journal of Housing Economics, Elsevier, vol. 5(1), pages 87-104, March.
  16. Erol, Isil & Patel, Kanak, 2005. "Default risk of wage-indexed payment mortgage in Turkey," Journal of Housing Economics, Elsevier, vol. 14(3), pages 271-293, September.
  17. Joseph B. Lipscomb & John T. Harvey & Harold Hunt, 2003. "Exchange-Rate Risk Mitigation with Price-Level-Adjusting Mortgages: The Case of the Mexican UDI," Journal of Real Estate Research, American Real Estate Society, vol. 25(1), pages 23-42.
Full references (including those not matched with items on IDEAS)

This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

When requesting a correction, please mention this item's handle: RePEc:ire:issued:v:010:n:01:2007:p:48-92. 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: (IRER Secretary Office/Webmaster)

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.

If references are entirely missing, you can add them using this form.

If the full references list an item that is present in RePEc, but the system did not link to it, you can help with 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 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.

This information is provided to you by IDEAS at the Research Division of the Federal Reserve Bank of St. Louis using RePEc data.