Planning Your Own Debt

We model the Danish market for mortgage backed securities with a two-factor interest rate model and use a stochastic programming approach to analyse how an individual home-owner should initially compose and subsequently readjust his mortgage in an optimal way. Results show that the 'rules of thumb' used by financial institutions are reasonable, although best suited for more aggressive mortgagors, for whom the delivery option is of some value. More risk-averse investors should also re-adjust frequently, but use more diversified portfolios. Results are insensitive to whether a one- or two-factor model is used, provided the former is suitably calibrated.