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- Title
Mortgage Prepayment with an Uncertain Holding Period.
- Authors
Yang, Tyler T.; Maris, Brian A.
- Abstract
A discrete-time-option pricing model is developed to value a mortgage and its embedded prepayment option when the effective life of the mortgage is a random variable with a probability distribution of known parameters. The model can be applied when the borrower's ex ante expectation of his tenure follows any probability distribution bounded to the left at zero. The Gamma distribution is used to illustrate the model. The pricing model is further applied to determine the conditions under which financially motivated prepayment is optimal. The results show that the certainty model understates the Interest Rate Differential needed to justify prepayment (IRD) for short Expected Holding Period (EHP) borrowers and overstates the IRD for long EHP borrowers. When the EHP is relatively long, the certainty model provides relatively good estimates of IRD during the beginning years of the mortgage life. Under most other conditions, the estimates of the certainty holding period model are biased.
- Subjects
MORTGAGE loans; BANK loans; INVESTMENT interest; DISTRIBUTION (Probability theory); PROBABILITY theory; PRICING; ECONOMIC policy
- Publication
Journal of Real Estate Finance & Economics, 1996, Vol 12, Issue 2, p179
- ISSN
0895-5638
- Publication type
Article
- DOI
10.1007/BF00132266