Please use this identifier to cite or link to this item: https://doi.org/10.1016/j.jedc.2007.01.016
Title: Intensity-based framework and penalty formulation of optimal stopping problems
Authors: Dai, M. 
Kwok, Y.K.
You, H.
Keywords: Callable feature
Event risk
Intensity approach
Linear complementarity formulation
Mortgage prepayment
Penalty method
Issue Date: Dec-2007
Citation: Dai, M., Kwok, Y.K., You, H. (2007-12). Intensity-based framework and penalty formulation of optimal stopping problems. Journal of Economic Dynamics and Control 31 (12) : 3860-3880. ScholarBank@NUS Repository. https://doi.org/10.1016/j.jedc.2007.01.016
Abstract: Financial derivatives commonly contain premature termination clauses, which are embedded rights held by the holder or writer. Well known examples of these stopping rights include the early exercise right in American options, the callable right in callable securities and the prepayment right in mortgage loans. In this paper, we show how to model the mortgagor's prepayment in mortgage loans and the issuer's call in the American warrant as an event risk using the intensity based approach, where the propensity of prepayment or calling is modeled by the intensity of a Poisson process. We illustrate that the corresponding pricing formulation resembles the penalty approximation approach commonly used in the solution of the linear complementarity formulation of an optimal stopping problem. We obtain several theoretical results on the prepayment strategies of mortgage loans and calling policies of American warrants. We also propose robust second order accurate numerical schemes for solving the penalty formulation of an optimal stopping problem. © 2007 Elsevier B.V. All rights reserved.
Source Title: Journal of Economic Dynamics and Control
URI: http://scholarbank.nus.edu.sg/handle/10635/103435
ISSN: 01651889
DOI: 10.1016/j.jedc.2007.01.016
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