Interest-Only and Principal-Only Mortgage Strips as Interest-Rate Contingent Claims

Brian A Maris and Tyler T Yang

The Journal of Real Estate Finance and Economics, 1996, vol. 13, issue 3, 187-202

Abstract: Interest-only (IO) and principal-only (PO) mortgage strips are valued in a stochastic interest-rate environment. The prepayment rate of the underlying mortgages is affected by two considerations not present in the "pure" financially rational model: (1) The property owner's holding period is assumed to follow a Gamma distribution, resulting in the possibility of prepayment due to the sale of the property (i.e., prepayment that is "too early" based on market interest rates); and (2) borrowers are assumed to face heterogeneous transaction costs related to refinancing the existing mortgage, and delay refinancing when market conditions make it optimal to do so (refinancing "too late"). Properties of IO-PO strips are identified by the finite difference method. Copyright 1996 by Kluwer Academic Publishers

Date: 1996
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