Abstract
A model of rational mortgage refinancing is developed where the drift and volatility of interest rate process switch between two regimes. Because of the possibility of a regime shift, the optimal refinancing policy is characterized by the different threshold of interest differential for each regime. Numerical simulation demonstrates that the optimal refinancing threshold in each regime can be smaller or larger than the threshold under single-regime models. Finally, we evaluate the predictions of the model, based on the estimated parameters for a two-regime model to capture the evolution of the mortgage rates in the US. Our model can produce both late and early refinancing, which is consistent with the observed refinancing behavior.
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The views expressed in this paper are solely those of the authors and do not necessarily reflect official positions of the Sumitomo Trust and Banking Co., Ltd.
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Kimura, T., Makimoto, N. Optimal Mortgage Refinancing with Regime Switches. Asia-Pac Finan Markets 15, 47–65 (2008). https://doi.org/10.1007/s10690-008-9072-2
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DOI: https://doi.org/10.1007/s10690-008-9072-2