Mortgages are fixed-income instruments with embedded interest rate, prepayment and default risks Because of the huge market volume, its pricing and risk analysis has been a popular research subject over the past two decades. The unique feature of an MBS compared with a straight bond is the uncertainty of the timing of the principal being returned.
That is, the actual cash flows of an MBS are driven by the realized prepayment rates, which in turn are mainly driven by the realized market interest rate scenario. The prepayment behavior could be modeled by a ruthless option pricing approach (see Kau et al. (1992) for this line of approach) or an empirically estimated approach (see Calhoun and Deng (2002) for this line of approach).
Following Hall (1985), many researchers applied option pricing models to value mortgages and mortgage-backed securities with lattice or Monte Carlo approaches. The pure option approach literature assumes that a ruthless borrower would exercise these embedded options so as to minimize the value of the mortgage, which is a liability to the borrower. However, empirical evidence showed that the prepayment and default options are usually not exercised optimally, at least at the finite risk factors models.
The prepayment rates implied by the ruthless prepayment option models are vastly different from the market experience. Deng, Quigley, and Van Order (2000) refer the fact that most households do not optimally exercise the prepayment option, and call them "wood heads". Stanton (1995) and others attempt to explain the non-optimal exercise of the options by the presence of refinancing transaction costs. However, after a few refinement of the model, the implied prepayment cost is still far higher than reasonable. As a result, almost 20 years after the prepayment option theory introduced by Hall (1985), this approach still remains at the academic research stage and has not been adopted by industry practitioners.
