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INDIFFERENCE VALUATION OF MORTGAGE‐BACKED SECURITIES IN THE PRESENCE OF PREPAYMENT RISK
Authors:Ti Zhou
Institution:The University of Texas at Austin
Abstract:We present a utility‐based methodology for the valuation and the risk management of mortgage‐backed securities subject to totally unpredictable prepayment risk. Incompleteness stems from its embedded prepayment option which affects the security's cash flow pattern. The prepayment time is constructed via deterministic or stochastic hazard rate. The relevant indifference price consists of a linear term, corresponding to the remaining outstanding balance, and a nonlinear one that incorporates the investor's risk aversion and the interest payments generated by the mortgage contract. The indifference valuation approach is also extended to the case of homogeneous mortgage pools.
Keywords:mortgage‐backed securities  totally unpredictable prepayment risk  hazard rate  indifference valuation
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