intensity-based valuation of residential mortgages an.pdf

Intensity-based Valuation of Residential Mortgages: an Analytically Tractable Model∗ Vyacheslav GorovoyÜ Vadim Linetskyá June 20, 2006 First Version: October 2005 Final Version: June 2006 To appear in Mathematical Finance Abstract This paper presents an analytically tractable valuation model for residential mortgages. The random mortgage prepayment time is assumed to have an intensity process of the form h = h (t) + γ (k − r )+ , where h (t) is a deterministic function of time, r is the short rate, t 0 t 0 t and γ and k are scalar parameters. The first term models exogenous prepayment independent of interest rates (e.g., a multiple of the PSA prepayment function). The second term models refinancing due to declining interest rates and is proportional to the positive part of the distance between a constant threshold level and the current short rate. When the short rate follows a CIR diffusion, we are able to solve the model analytically and find explicit expressions for the present value of the mortgage contract, its principal-only and interest-only parts, as well as their deltas. Mortgage rates at origination are found by solving a non-linear equation. Our solution method is based on explicitly constructing an eigenfunction expansion of the pricing semigroup, a Feynman-Kac semigroup of the CIR diffusion killed at an additive functional that is a linear combination of the integral of the CIR process and an area below