Valuation of the Embedded Prepayment Option of Mortgage-Backed Securities

Mortgage-backed securities (MBS for short) combine features of both bonds and options. The investor in the MBS has purchased a fully amortizing bond, with known coupon rate and maturity date. However, at the same time the investor has written a call option to the mortgage borrower. The homowner’s privilage to refinance his or her mortgage at any point in time complicates attempts to price the MBS. Further complications arise due to the homowners’ propensity to prepay their mortgage, even if this decision may not appear to Be economically desirable. For example, a homeowner may sell or refinance the house in an unfavorable interest rate environment. Reasons for this decision include, for example, family dynamics (birth, death, divorce) and employment opportunites (relocation). These keywords were added by machine and not by the authors. This process is experimental and the keywords may be updated as the learning algorithm improves.