Valuing prepayment and default in a fixed-rate mortgage: A bivariate binomial options pricing technique

This paper uses a bivariate binomial options pricing technique to value prepayment and default options in a fixed-rate mortgage. By forcing the two underlying state variables (real-estate value and spot rate of interest) to undergo transformations, a computationally simple bivariate binomial lattice is created. Compared with the finite-difference model of Kau ei al. (1992, 1994), large option value differences lover 5% of the loan) are rare and occur when there is a downward-sloping term structure and slow adjustment. The smallest option value differences (less than 0.5% of the loan) tend to occur when interest-rate volatility and real estate volatility are low.