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Modelling Competitive Mortgage Termination Option Strategies: Default vs Restructuring and Prepayment vs Defeasance

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  • Lok Man Michel Tong
  • Gianluca Marcato

Abstract

We build a two-stage competing risk model for pricing four types of early Termination options written on commercial mortgages: default vs restructuring and prepayment vs defeasance as two pairs of competitions. It is the first study to consider restructuring as a “competitor” with default. The key feature of our model is to introduce collateral underlying property market supply constraints into a property Price process which would determine values of early termination options. Our simulations find out greater probability to restructure mortgages by reducing interest and extending maturity and to prepay in cash. We also prove that tightening property supply constraints pushes up values of default, restructuring and prepayment by pricing their analogous options: default (a series of compound European Call on Put options), mortgage restructuring (an exchange option between mortgages with different cash flow structures), prepayment in cash (a series of compound European Call on Call options),and defeasance (an exchange option of more liquid assets with less liquid ones)in different scenarios. Therefore, we suggest controlling property supply constraints as an alternative risk management measure for mortgage markets.

Suggested Citation

  • Lok Man Michel Tong & Gianluca Marcato, 2018. "Modelling Competitive Mortgage Termination Option Strategies: Default vs Restructuring and Prepayment vs Defeasance," ERES eres2018_300, European Real Estate Society (ERES).
  • Handle: RePEc:arz:wpaper:eres2018_300
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    References listed on IDEAS

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    More about this item

    Keywords

    Defeasance; Mortgage Default; Prepayment; Property Supply Constraints; Restructuring;
    All these keywords.

    JEL classification:

    • R3 - Urban, Rural, Regional, Real Estate, and Transportation Economics - - Real Estate Markets, Spatial Production Analysis, and Firm Location

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    This paper has been announced in the following NEP Reports:

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