The probability of prepayment

Prepayment is a risk of holding a mortgage or derivative security. Incorrect pricing of prepayment risk leads to increased volatility and uncertainty in mortgage security markets. This article prices prepayment risk within an underlying callable bonds model. To price mortgages accurately, a probability of prepayment is required. A mortgage is a callable bond with a package of an option to prepay currently and a sequence of options to prepay up to the date of maturity. This sequence is summarized by a compound option. The probability of prepayment is determined by the prices of the current call and this compound option. These option prices depend on market interest rates and age, and on the contract terms of the originated mortgage.