The Valuation and Analysis of Adjustable Rate Mortgages

James Kau (), Donald Keenan, Walter Muller and James F. Epperson
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James F. Epperson: University of Alabama---Huntsville

Management Science, 1990, vol. 36, issue 12, 1417-1431

Abstract: Securities whose payoffs depend upon the actual path of the underlying state variables pose problems for standard backward-valuation techniques. In this paper, we show that there is a method of solving such problems that requires the addition of but a single auxiliary state variable. The technique is illustrated by examining an adjustable rate mortgage (ARM) with yearly and lifetime caps. The ARM amortizes and can be prepaid at any time. We also handle other prominent features of ARMs including points and teasers. This method of using a single auxiliary state variable to handle path dependencies is a general one, applicable to more complex models of the economic environment and to other financial contracts.

Keywords: adjustable-rate mortgages; option theory; mortgage; pricing mortgages (search for similar items in EconPapers)
Date: 1990
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Persistent link: https://EconPapers.repec.org/RePEc:inm:ormnsc:v:36:y:1990:i:12:p:1417-1431

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