Residential Mortgage Prepayment: Lender's Arbitrage Approach

Y. Goncharov (USA)


prepayment, option-based approach, lender’s arbitrage.


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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