ANALYSING MORTGAGE DEFAULT USING DINOMIAL TREE OPTION PRICING MODEL
CHONG GEK HUI
CHONG GEK HUI
Citations
Altmetric:
Alternative Title
Abstract
A borrower who mortgaged his house to the lender in exchange for a loan has an option
to default on the contractual responsibilities like making payments. This option is
particularly valuable in times of volatile market conditions. That is to say when house
price fluctuations are high and in the downward trend, prices are falling, that will make
default option more valuable. It is because when house price fall below the remaining
mortgage balance, in theoretic terms, the borrower will default since the mortgage is
now not as valuable as it used to be, defaulting on the loan will give more value to the
borrower.
This study attempts to estimate this default option value using binomial tree option
pricing approach. A sensitivity analysis is conducted to determine how changes in each
parameter may affect the option premium and the conclusions that can be drawn from it.
It was found that default option premium is at its most valuable when the house price is
high, loan term is long, loan-to-value ratio is high, interest rate is low and house price
volatility is high. The last parameter, house price volatility is something uncontrollable
by the lender as it is dependent upon the economic well-being of the country. What the
lenders are able to do is to work using the rest of the variables to price the default option
value within their contracts so as to safeguard their interest against the ruthless default
of borrowers. Another way is to look at mortgage insurance.
Keywords
Source Title
Publisher
Series/Report No.
Collections
Rights
Date
2003
DOI
Type
Thesis