Microfoundations of a mortgage prepayment function

  • James R. Follain
  • Louis O. Scott
  • Tl Tyler Yang
Article

DOI: 10.1007/BF00221530

Cite this article as:
Follain, J.R., Scott, L.O. & Yang, T.T. J Real Estate Finan Econ (1992) 5: 197. doi:10.1007/BF00221530

Abstract

This article focuses on the following question: how much of an interest rate decline is needed to justify refinancing a typical home mortgage? Modern option pricing theory is used to answer the question; this theory indicates that the answer depends upon several factors, which include the volatility of interest rates and the expected holding period of the borrower. The analysis suggests that the commonly espoused “rule of thumb” refinance if the interest rate declines by 200 basis points — is a fair approximation to the more precisely derived differential for many households. We also construct the prepayment behavior of a pool of mortgages in which the expected holding periods of the borrowers in the pool vary. The prepayment behavior of this simulated pool is used to generate a series of empirically testable hypotheses regarding the likely shape of an actual prepayment function and its determinants. Finally, actual prepayment data are used to estimate a hazard function that explains prepayment behavior. We find that the estimated model understates prepayment behavior relative to that predicted by the simulation model, which suggests that the simple option pricing model is not adequate to explain aggregate prepayment behavior.

Key words

mortgage prepaymentrefinancingoptionsmortgage-backed securities

Copyright information

© Kluwer Academic Publishers 1992

Authors and Affiliations

  • James R. Follain
    • 1
  • Louis O. Scott
    • 2
  • Tl Tyler Yang
    • 3
  1. 1.Economics Department, Maxwell School of Citizenship and Public AffairsSyracuse UniversitySyracuse
  2. 2.Terry College of Business, Department of FinanceUniversity of GeorgiaAthens
  3. 3.Department of Finance, Real Estate and LawCalifornia State UniversityLong Beach, Long Beach