Rational Prepayment and the Valuation of Mortgage-Backed Securities

Richard Stanton

406 citations0/0 files storedReview of Financial Studies

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Abstract

This article presents a new model of mortgage prepayments, based on rational decisions by mortgage holders. These mortgage holders face heterogeneous transaction costs, which are explicitly modeled. The model is estimated using a version of Hansen’s (1982) generalized method of moments, and is shown to capture many of the empirical features of mortgage prepayment. Estimation results indicate that mortgage holders act as though they face transaction costs that far exceed the explicit costs usually incurred on refinancing. They also wait an average of more than a year before refinancing, even when it is optimal to do so. The model fits observed prepayment behavior as well as the recent empirical model of Schwartz and Torous (1989). Implications for pricing mortgage-backed securities are discussed.

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References

1985A Theory of the Term Structure of Interest Rates 1989Prepayment and the Valuation of Mortgage-Backed Securities 1978Finite Difference Methods and Jump Processes Arising in the Pricing of Contingent Claims: A Synthesis 1981Valuation of GNMA Mortgage-Backed Securities 1989Security Markets: Stochastic Models.

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