Effects of Noise on Optimal Exercise Decisions: The Case of Risky Debt Secured by Renewable Lease Income

Paul D. Childs (), Steven H. Ott () and Timothy J. Riddiough ()

The Journal of Real Estate Finance and Economics, 2004, vol. 28, issue 2_3, 109-121

Abstract: This paper considers the valuation and default exercise policy of risky coupon debt that is secured by a lease-encumbered noisy real asset. For parameter values used in our analysis, asset value noise is shown to reduce the value of waiting to default. Moreover, the borrower is shown to delay default exercise until the noisy signal of asset value is far into-the-money. This latter finding provides an information-based explanation for the apparent under-exercise of the mortgage default option that has been observed in the literature. An implication of this finding is that, if the claimholder recognizes that noise exists, but the empiricist--who is trying to compare observed exercise policy with that predicted by a noiseless model of asset prices--does not, a "sub-optimal" exercise policy may be inferred when in fact the policy is rational given the information available. This explanation is consistent with evidence from mortgage default studies as to why the observed default exercise boundary is lower than that predicted by standard theoretical option-based models.

Date: 2004
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