Residential Mortgage Prepayment: Lender's Arbitrage Approach

Y. Goncharov (USA)

Keywords

prepayment, optionbased approach, lender’s arbitrage.

Abstract

One class of approaches to prepayment modeling in the lit erature assumes that refinancing rates are governed by the borrowers’ liability in a fashion similar to American option exercise policy. However, a straightforward arbitrage argu ment is not applicable in this case since residential borrow ers do not trade their liabilities. In this paper, we introduce a new approach to model the prepayment which is built on an idea of lender’s arbitrage. The novelty of this approach, in particular, is that it shows that the “burn-out” effect has a direct influence on the borrowers’ refinancing incentives.

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