Pricing Mortgage Prepayment Options Without a Volatility Market

Summary

The document asks how to value and hedge mortgage early payment options in emerging markets where swaptions, caps, and floors are unavailable. It considers starting with a one factor short rate model, such as a Black-Derman-Toy style tree, to value cash flows associated with exercise, and asks whether more elaborate approaches such as the Libor Market Model are warranted.

The central challenge is calibration: swap rates may provide a yield curve, but the usual option implied volatility inputs are missing. The author asks how to estimate volatility and other parameters from available instruments, and how to benchmark valuations when there is no active market for comparable rate options. The document poses these questions but provides no proposed calibration method, pricing results, or hedge tests. Its usefulness is therefore as a statement of model selection and data limitations rather than a resolved valuation framework; model complexity alone cannot replace missing market evidence.

Key ideas

• Mortgage prepayment can be viewed as an embedded option requiring valuation and hedging.
• A one factor short rate model is proposed as a possible starting point when rate options are unavailable.
• A yield curve from swaps may be observable even when option volatility is not.
• Calibration and benchmarking are unresolved when comparable option prices are absent.
• The document does not compare model performance or recommend a specific parameter estimation method.

Tags

# Pricing interest rate options in emerging markets


# Pricing interest rate options in emerging markets












I've been thinking how to price the early payment of mortgages in banks from emerging markets, where swaptions/caps/floors aren't available, and how to hedge this kind of options. At first I thought about implementing simple methodologies, like one factor short-rate models (in my sight the BDT model) for discounting the future cash flows that I could receive if the options are exercised.

So I would like to know if it's a good a idea to start pricing with this kind of models. How good or bad could this end up being? (compared to more sophisticated models). Should I spend time trying to calculate more complete models like the LMM or so? If so, which instruments should I use to get the right parameters?

Many models start assuming that there is an observable swaption/cap/floor market, but if there isn't such a market, how should parameters be estimated? For example, I could get the zero yield from the swap market, but what about the vol? How do I benchmark my models?

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.