Option Theory and Defaultable Mortgage Pricing

Abstract

The existing mortgage pricing literature either fails to consider the default option or gives numerical results only. Solutions using numerical methods not only do not provide the intuition of analytic solutions, but also are very expensive in computation time, since a supercomputer is frequently required. We, therefore, have employed the Cox-Ross [1976] approach to price a fixed-rate mortgage with a default option. We are able to provide analytic solutions, comparative statistics and more simulation results not available in existing models.