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Optimal mortgage refinancing: application of bond valuation tools to household risk management

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  • Andrew Kalotay
  • Deane Yang
  • Frank Fabozzi

Abstract

Despite the enormous volume of refinancing activity in conventional residential mortgages, reaching record levels during recent years of historically low interest rates, the solution to the problem of how to time refinancing decisions optimally has remained elusive. It is recognized that the decision should depend, among other factors, on the 'call' options of the outstanding and the new mortgage. Determining the value of these options is a challenge in the absence of an observable optionless mortgage yield curve. We solve this by calibrating a benchmark interest rate process to the value of the new mortgage and then apply the notion of refinancing efficiency to the timing decision. In particular, risk-averse decision makers can use refinancing efficiency to measure how close to optimal a refinancing is. We analyse the sensitivity of the decision to interest rate volatility and also show how to incorporate homeowner-specific considerations, namely borrowing horizon and income taxes. While calibration and refunding efficiency are well-known techniques in bond analysis, there is no evidence, hitherto, of their application to the mortgage-refinancing problem.

Suggested Citation

  • Andrew Kalotay & Deane Yang & Frank Fabozzi, 2008. "Optimal mortgage refinancing: application of bond valuation tools to household risk management," Applied Financial Economics Letters, Taylor and Francis Journals, vol. 4(2), pages 141-149.
  • Handle: RePEc:taf:apfelt:v:4:y:2008:i:2:p:141-149
    DOI: 10.1080/17446540701493729
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    References listed on IDEAS

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    1. Longstaff, Francis A., 2002. "Optimal Recursive Refinancing and the Valuation of Mortgage-Backed Securities," University of California at Los Angeles, Anderson Graduate School of Management qt19k7479t, Anderson Graduate School of Management, UCLA.
    2. John D. Finnerty, & Douglas R. Emery,, 2001. "Debt Management:: A Practitioner's Guide," OUP Catalogue, Oxford University Press, number 9780875846170.
    3. Paul Bennett & Richard Peach & Stavros Peristiani, 2000. "Implied Mortgage Refinancing Thresholds," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 28(3), pages 405-434.
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    Cited by:

    1. Poitras, Geoffrey & Zanotti, Giovanna, 2016. "Mortgage contract design and systemic risk immunization," International Review of Financial Analysis, Elsevier, vol. 45(C), pages 320-331.

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