Abstract
Interest-only (IO) and principal-only (PO) mortgage strips are valued in a stochastic interest-rate environment. The prepayment rate of the underlying mortgages is affected by two considerations not present in the “pure” financially rational model: (1) The property owner's holding period is assumed to follow a Gamma distribution, resulting in the possibility of prepayment due to the sale of the property (i.e., prepayment that is “too early” based on market interest rates); and (2) borrowers are assumed to face heterogeneous transaction costs related to refinancing the existing mortgage, and delay refinancing when market conditions make it optimal to do so (refinancing “too late”). Properties of IO/PO strips are identified by the finite difference method.
This is a preview of subscription content, log in via an institution to check access.
Similar content being viewed by others
References
Archer, Wayne R., and David C. Ling. (1993). “Pricing Mortgage-Backed Securities: Integrating Optimal Call and Empirical Models of Prepayment,” AREUEA Journal 21 (Winter), 373–404.
Bartlett, William W. (1989). Mortgage Backed Securities, Products, Analysis, Trading. New York: New York Institute of Finance, ch. 13.
Brennan, Michael J., and Eduardo S. Schwartz. (1985). “Determinants of GNMA Mortgage Prices,” AREUEA Journal 13 (Fall), 209–228.
Chen, Andrew H., and David C. Ling. (1989). “Optimal Mortgage Refinancing with Stochastic Interest Rates,” AREUEA Journal 17 (Fall), 278–299.
Chen, Ren-Raw, and T. L. Tyler Yang. (1995). “The Relevancy of Interest Rate Processes in Pricing Mortgage-Backed Securities,” Journal of Housing Research 6, 315–332.
Clauretie, Terrence M., and James R. Webb. (1993). The Theory and Practice of Real Estate Finance. Fort Worth: Dryden Press.
Cox, John C., Jonathan E. Ingersoll Jr., and Stephen A. Ross. (1985). “A Theory of the Term Structure of Interest Rates,” Econometrica 53 (March), 385–408.
Dunn, Kenneth B., and Chester S. Spatt. (1988). “Private Information and Incentives: Implications for Mortgage Contract Terms and Pricing,” Journal of Real Estate Finance and Economics 1, 47–60.
Fabozzi, Frank J., and Franco Modigliani. (1992). Mortgage and Mortgage-Backed Securities Markets. Boston: Harvard Business School Press.
Follain, James R., Louis O. Scott, and T. L. Tyler Yang. (1992). “Microfoundations of a Mortgage Prepayment Function,” Journal of Real Estate Finance and Economics 5 (June), 197–217.
Green, Jerry, and John B. Shoven. (1986). “The Effects of Interest Rates on Mortgage Prepayments,” Journal of Money, Credit, and Banking 18 (February), 41–59.
Hall, Arden R. (1985). “Valuing the Mortgage Borrower's Prepayment Option,” AREUEA Journal 13 (Fall), 229–247.
Harding, John. (1995). “Rational Mortgage Valuation Using Optimal Intertemporal Refinancing Strategies and Heterogeneous Borrowers.” Working paper, University of California at Berkeley, October.
Hull, J., and A. White. (1990). “Valuing Derivative Securities Using the Explicit Finite Difference Method,” Journal of Financial and Quantitative Analysis 25 (March), 87–100.
Kau, James B., Donald C. Keenan, Walter J. Muller III, and James F. Epperson. (1992). “Generalized Valuation Model for Fixed-Rate Residential Mortgages,” Journal of Money, Credit, and Banking 24 (August), 279–299.
Kau, James B., Donald C. Keenan, and Taewan Kim. (1993). “Transaction Costs, Suboptimal Termination, and Default Probabilities,” AREUEA Journal 21 (Fall), 247–263.
Rendleman, Richard J. Jr., and Brit J. Bartter. (1980). “The Pricing of Options on Debt Securities,” Journal of Financial and Quantitative Analysis 15 (March), 11–24.
Roll, Richard. (1986). “Stripped Mortgage Backed Securities,” Mortgage Securities Research (Goldman Sachs, New York) (October).
Stanton, Richard. (1995). “Rational Prepayment and the Valuation of Mortgage-Backed Securities,” Review of Financial Studies 8 (Fall), 677–708.
Waldman, Michael, Mark Gordon, Thomas A. Zimmerman, and K. Jeanne Person. (1987). “Interest Only and Principal Only STRIPS,” Mortgage Research (Saloman Brothers, Inc., New York) (May).
Yang, T. L. Tyler, and Brian Maris. (1993). “Mortgage Refinancing with Asymmetric Information,” AREUEA Journal 21 (Winter), 481–510.
Yang, T. L. Tyler, and Brian Maris. (1996). “Mortgage Prepayment With an Uncertain Holding Period,” Journal of Real Estate Finance and Economics, in press.
Author information
Authors and Affiliations
Rights and permissions
About this article
Cite this article
Maris, B.A., Yang, T.T. Interest-only and principal-only mortgage strips as interest-rate contingent claims. J Real Estate Finan Econ 13, 187–202 (1996). https://doi.org/10.1007/BF00217390
Issue Date:
DOI: https://doi.org/10.1007/BF00217390