JISE


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Journal of Information Science and Engineering, Vol. 31 No. 3, pp. 925-942


Outstanding Principal as Prepayment Value: A Closed-Form Formula for Mortgage Pricing


YI-CHENG TSAI1,2, CHIN-LAUNG LEI1, JAN-MING HO2, MING-YANG KAO3 AND SZU-LANG LIAO4 
1Electrical Engineering and Computer Science 
National Taiwan University 
Taipei, 116 Taiwan 
2Institute of Information Science 
Academia Sinica 
Taipei, 115 Taiwan 
3Electrical Engineering and Computer Science 
Northwestern University 
Evanston, IL 60201, USA 
4Department of Money and Banking 
National Chung-Cheng University 
Taipei, 621 Taiwan 
E-mail: yicheng@iis.sinica.edu.tw; lei@cc.ee.ntu.edu.tw; 
hoho@iis.sinica.edu.tw; kao@northwestern.edu; liaosl@nccu.edu.tw


    Mortgage is one of the most popular instruments in the financial markets. In this study, we consider three actions, i.e., to default, to prepay, and to maintain the mortgage, that a borrower may have in mortgage horizon. We provide an effective pricing formula, which not only considers the effect that default might affect the mortgage value, but also accurately computes the impact due to prepayment risk. Our model defines the prepayment value of the mortgage as the amount of outstanding principal, in contrast to defining prepayment value as a constant proportion of maintaining value of the mortgage. We present a new closed-form pricing formula of risky mortgage and also derive its yield to maturity, duration and convexity to provide a framework for risk management.


Keywords: mortgage, prepayment, default, yield to maturity, duration, convexity, risk management

  Retrieve PDF document (JISE_201503_09.pdf)