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Valuation of Mortgages Without Prepayment Penalties

Caspari, Saskia (2018) Valuation of Mortgages Without Prepayment Penalties.

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Abstract:The purpose of this research is to evaluate the refinancing option in Dutch residential mortgages without prepayment penalties. To achieve this goal, we define a new interest rate framework to model mortgage rate, we explicitly characterize borrowers' refinancing behavior, and we develop a simulation model to evaluate the worth of the penalty-free refinancing option. The result is reported in terms of a risk premium the lender should charge on top of the annual rate of a regular mortgage with prepayment penalties. However, we find that the initial assumptions on future mortgage rate development and behavioral aspects have a large impact on the simulation outcome. Furthermore, penalty-free refinancing can come with considerable downside risk for the lender, and ethical issues can arise when the risk premium the lender charges is higher than the true expected loss due to refinances. Future research needs to address these open ends. For example, the mortgage contract conditions could be re-designed, such that the payoff for the lender becomes less risky, while the borrower still perceives the product in a positive manner and no ethical boundaries are violated.
Item Type:Essay (Master)
Dutch Mortgage Funding Company, Den Haag, Netherlands
Faculty:BMS: Behavioural, Management and Social Sciences
Subject:83 economics
Programme:Industrial Engineering and Management MSc (60029)
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