PREFERENTIAL RATE MORTGAGES - A BINOMIAL TREE APPROACH

Abstract

Preferential Rate Mortgages (PRMs) are now commonplace in Singapore. These will continue to exist as attractive packages for borrowers and as useful sales tools for lenders. In view of the great variety of PRMs available on the market and the possible securitisation of PRMs, an accurate and correct valuation framework must be developed for the benefit of the mortgagor, mortgagee and investor to facilitate comparison and pricing. The traditional Discounted Cash Flow approach, albeit modified by simulation technique, cannot handle implicit options in mortgages. Option pricing theory is a unique and viable valuation approach that captures the mortgagor's right to prepay or default. By valuing the incremental value of a PRM (over and above an Adjustable Rate Mortgage), which consists of a net present cash value component as well as a prepayment option, using the DCF method for the first component and the option pricing approach for the second, the significance of an implicit option value can be revealed. The results exposed the shortcomings of the traditional DCF approach and provided some useful insights for the prospective borrower. Firstly, the implicit option value is significant; the omission of which results in serious discrepancies in the assessed incremental value. Secondly, the value of right to prepay varies with the interplay of current inter-bank rate, interest rate volatility and the option life: this option value is positively related to the interest rate volatility and the option life, negatively to the current inter-bank rate and becomes less sensitive to the first two variables as option life increases. Finally, it was thus shown that the comparison of PRMs based only on the extent of discount, length of promotional period or the NPV figure could be misleading. The only objective way to compare or price PRMs is by the use of options approach to valuation.