Reforming Housing Finance - Perspectives from Denmark

This paper investigates the effect of adding a distinct feature of the Danish mortgage market to the market in the United States. This feature, a buyback option, enables mortgagors to buy back their share of the mortgage-backed security at market price. Extending a standard referenced pricing model, the findings indicate that the introduction of the buyback option reduces the credit spread required by the financial intermediary by 23%, potentially reducing the contingent liability of the U.S. government. Furthermore, the buyback option protects households against the risk of being locked in after an increase in interest rates. This could be of particular benefit to low-to-middle income households.

Valuation of Path-Dependent Interest Rate Derivatives in a Finite Difference Setup

In this paper we study and implement a finite difference version of the augmented state variable approach proposed by Hull & White (1993) that allows for pathdependent securities. We apply the method to a class of path-dependent interest rate derivatives and consider several examples including mortgage backed securities and collateralized mortgage obligations. The efficiency of the method is assessed in a comparative study with Monte Carlo simulation and we find it to be faster for a similar accuracy.Path-dependent Options; Finite Difference; Mortgage Backed Securities

Mortgage Choice - The Danish Case

In this paper we analyze the mortgage choice faced by Danish borrowers. Based on an analysis of the most popular Danish mortgage products, we argue that Adjustable-Rate Mortgages (ARM) with life time caps will combine the most attractive features from straight ARMs and callable Fixed-Rate Mortgages (FRM). Furthermore, we find the delivery option embedded in Danish mortgages to be an important feature, which protects households from the risk of insolvency by facilitating a closer match between assets and liabilities in the household portfolio.Mortgage; Choice; Valuation; Delivery Option; Prepayment

On the Suboptimality of Single-Factor Exercise Strategies for Bermudan Swaptions

In this paper we examine the cost of using recalibrated single-factor models to determine the exercise strategy for Bermudan swaptions in a multi-factor world. We demonstrate that single-factor exercise strategies applied in a multi-factor world only give rise to economically insignificant losses. Furthermore, we find that the conditional model risk as defined in Longstaff, Santa-Clara & Schwartz (2001), is statistically insignificant given the number of observations. Additional tests using the Primal-Dual algorithm of Andersen & Broadie (2001) indicate that losses found in Longstaff et al. (2001) cannot as claimed be ascribed to the number of factors. Finally we find that for valuation of Bermudan swaptions with long exercise periods, the simple approach proposed in Andersen (2000) is outperformed by the Least Square Monte Carlo method of Longstaff & Schwartz (2001) and, surprisingly, also by the exercise strategies from the single-factor models.Bermudan swaption; American option; Least Square Monte Carlo; Libor Market Model; Model Risk; Model Calibration

Efficient Control Variates and Strategies for Bermudan Swaptions in a Libor Market Model

This paper concerns the problem of valuing Bermudan swaptions in a Libor market model. In particular we consider various efficiency improvement techniques for a Monte Carlo based valuation method. We suggest a simplification of the Andersen (2000) exercise strategy and find it to be much more efficient. Furthermore, we test a range of control variates for Bermudan swaptions using a control variate technique for American options proposed in Rasmussen (2002). Application of these efficiency improvements in the Primal-Dual simulation algorithm of Andersen & Broadie (2001) improves both upper and lower bounds for the price estimates. For the Primal-Dual simulation algorithm we examine the variance-bias trade-off between the numbers of outer an inner paths. Finally, we demonstrate that the presence of stochastic volatility increases the expected losses from using the simple strategy in Andersen (2000).Bermudan Swaptions; Control Variates; Exercise Strategy; Primal-Dual Algorithm; Stochastic Volatility