A note on applying option pricing theory to emerging mortgage and mortgage-backed securities markets

Abstract

Option-based models have been the dominant paradigm for researches on the risks and pricing of mortgages and Mortgage-Backed Securities (MBS) in the USA. However, the adaptability and flexibility of option-based models in the emerging mortgage markets has been obviously neglected. This study provides the first analysis of the potential strengths and weaknesses of application of the option pricing theory to emerging markets with referring to both theoretical and empirical literatures. This study finds that the mortgage type, the attitude of mortgagees to risk and the institutional features are the key determinants of success of application of the option pricing theory to emerging mortgage and MBS markets. The option pricing literature in finance has been extended to study the risks and pricing of mortgages and MBS in the USA over the last three decades. However, given the robust and rapid growth of emerging mortgage and mortgage-related capital markets, there is surprisingly little known about to what extent the option pricing theory can be applied to the emerging mortgage and MBS markets in the global arena. The purpose of this study is to fill this gap by analysing the potential strengths and weaknesses of application of the option pricing models to emerging markets with specifically referring to both theoretical and empirical literatures.

Notes

¹In secondary market, the pass-through securities are pools of individual mortgage contracts. The analysis of the MBS performance depends on the understanding of the mortgage contracts’ behaviour; hence, this article will mainly focus on the mortgages valuations.

²To be more specific, there are two types of prepayment: endogenous, or ‘optimal’, and exogenous, or ‘suboptimal’ (Dunn and McConnell, 1981). The former is independent of the borrower's individual characteristics but only depends on the term structure; the latter arises from personal situation or characteristics, e.g. change in job, family size or marital status.

³It is Dunn and McConnell (1981) who first used the option pricing theory to model prepayments risk and Cunningham and Hendershott (1984) were the first to model mortgage defaults. After them, lots of researches using option pricing theory have been done to value prepayment risks or default risks. For example, for option-based prepayment models, see Green and Shoven (1986), Schwartz and Torous (1989) and Quigley and Van Order (1990); for option-based default models, see Epperson et al. (1985), Kau et al. (1995), Quigley and Van Order (1995) and others.

⁴When mortgagors obtain a loan, they agree to repay the loan using a predetermined amortization schedule. During this amortization period, borrowers can choose four payment alternatives: (1) making the scheduled payment; (2) paying off the loan entirely; (3) failing to make a payment and entering into default; or (4) making a payment that includes additional principal. Funds in excess of the required payment are termed curtailment.

⁵Most of these option-based models are in a reduced form. Reduced form mortgage valuation models include Schwartz and Torous (1989), Deng et al. (2000) and Deng and Quigley (2002).

⁶The empirical literatures on China mortgage pricing are very limited, but mainly include the works of Sun and Liu (2004), Deng et al. (2005) and Sun and Liu (2005). Only Deng et al. (2005) used option-based models for mortgage analysis; for Singapore mortgage market, see the works of Lum (1996) and Neo et al. (2003); for Hong Kong mortgage market, see the works of Gau and Wang (1990, 1994) and Koh and Ng (2004).