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The Pricing of Default-Free Mortgages


  • Stephen A. Buser
  • Patric H. Hendershott


In this paperwe examine the household's option to prepay or call a standard fixed-rate mortgage. Results based on simulation indicate that the value of this option is sensitive to the expected path of interest rates, the variation around that path, risk aversion and refinancing costs. Unfortunately, efforts to estimate the interest rate process (by us and by previous authors) have met with only limited success, and uncertainty exists regarding the degree of risk aversion and the magnitude of refinancing costs.Thus we conclude that the application of contingent-claims methodology to options on bonds is conceptually more difficult and operationally less reliable than is the analogous application to options on stocks.Despite these reservations concerning the use of our model as a technique for absolute valuation, preliminary findings on the effects of changes in mortgage contract design on the value of the prepayment option are encouraging. For example, our estimate of the relative values of the call options on 30- and 15-year mortgages and on level-payment and graduated-payment mortgages appear to be reasonably robust with respect to specifications of the interestrate process and the other parameters.These findings suggest that our model may be of considerable use within the context of relative or comparative valuation.

Suggested Citation

  • Stephen A. Buser & Patric H. Hendershott, 1984. "The Pricing of Default-Free Mortgages," NBER Working Papers 1408, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:1408
    Note: ME

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    References listed on IDEAS

    1. Richard, Scott F., 1978. "An arbitrage model of the term structure of interest rates," Journal of Financial Economics, Elsevier, vol. 6(1), pages 33-57, March.
    2. Vasicek, Oldrich, 1977. "An equilibrium characterization of the term structure," Journal of Financial Economics, Elsevier, vol. 5(2), pages 177-188, November.
    3. Marsh, Terry, 1980. " Equilibrium Term Structure Models: Test Methodology," Journal of Finance, American Finance Association, vol. 35(2), pages 421-435, May.
    4. Miller, Merton H. & Scholes, Myron S., 1978. "Dividends and taxes," Journal of Financial Economics, Elsevier, vol. 6(4), pages 333-364, December.
    5. Beckers, Stan, 1980. " The Constant Elasticity of Variance Model and Its Implications for Option Pricing," Journal of Finance, American Finance Association, vol. 35(3), pages 661-673, June.
    6. Robert C. Merton, 2005. "Theory of rational option pricing," World Scientific Book Chapters,in: Theory Of Valuation, chapter 8, pages 229-288 World Scientific Publishing Co. Pte. Ltd..
    7. Miller, Merton H, 1977. "Debt and Taxes," Journal of Finance, American Finance Association, vol. 32(2), pages 261-275, May.
    8. Bodie, Zvi & Friedman, Benjamin M, 1978. "Interest Rate Uncertainty and the Value of Bond Call Protection," Journal of Political Economy, University of Chicago Press, vol. 86(1), pages 19-43, February.
    9. Robert J. Shiller & John Y. Campbell & Kermit L. Schoenholtz, 1983. "Forward Rates and Future Policy: Interpreting the Term Structure of Interest Rates," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 14(1), pages 173-224.
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