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Rational and Behavioral Models of Embedded Option Exercise

Article Quant Q&A · Author: Tal Fishman
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Summary

The document contrasts rational exercise models with behavioral approaches for embedded options, such as mortgage refinancing rights and callable corporate debt. Borrowers and issuers may exercise based on private circumstances, including personal finances or plans to move, which can make their choices look suboptimal from an investor’s perspective. When these influences cannot be observed, a model may need to represent them as random factors.

The discussion raises whether fitting exercise behavior to market prices can capture those hidden influences and improve predictions or relative value estimates. It does not resolve that question: the sole answer points out that the preferred approach depends on the modeling purpose and that both approaches have merits. The note therefore frames the modeling trade-off but provides no comparative evidence, estimation procedure, or conclusion about which approach predicts better. Its scope is embedded options, where decision makers may have non-market incentives, rather than exchange-traded options.

Key ideas

  • Embedded options can be exercised based on private circumstances beyond market incentives.
  • Unobserved borrower or issuer factors may need to be modeled as random.
  • Observed exercise choices can appear irrational to investors while reflecting private objectives.
  • The discussion does not establish which modeling approach produces better predictions or relative value measures.

Tags

OptionsFixed incomeDerivatives pricing
Full text
# Which approach is better for modeling option exercise strategies, rational or behavioral?


# Which approach is better for modeling option exercise strategies, rational or behavioral?












This question is most relevant to the evaluation of embedded options, such as the refinancing option granted to borrowers in the mortgage and bank loan markets, or the call option present in some corporate bonds, than to exchange traded options.

Much more so than market participants in exchange traded options, which have purely market-based incentives, the borrowers and issuing entities which are granted embedded options often employ sub-optimal (irrational) exercise strategies. Sometimes, these only appear irrational to the lender/investor, when, in fact, they are optimal when considering other factors such as the borrower's personal financial condition or other factors (such as a homeowner's desire to move to a new house). In those cases, the difficulty from the modeler's perspective is that these factors are unobservable, and, hence, must be modeled as random. Other times, decision makers make truly sub-optimal decisions based on a private evaluation of the value of exercise that differs from a "correct" market-implied decision rule.

Which modeling approach leads to better predictions and better relative value measures?





Under the rational approach, how do you treat unobserved characteristics? Does the presence of unobserved characteristics make the rational approach ultimately equivalent to a market-implied behavioral approach? Is it even possible to fit the unobserved information directly to market data?

Open-ended Bounty Offer: We may not yet have a broad enough user base familiar with the pricing and modeling of embedded options to adequately answer this question. As such, I pledge to offer a bounty of 100 points to any user who can adequately answer this question. If you are a new user and you have come to this question long after activity has died down, then so long as I am still active on this site my offer remains in effect.

## Answer by Ian (score 2)

https://quant.stackexchange.com/a/2557

honestly your question is hard to understand. Are these two questions the same?

- "Does fitting sub-optimal option exercise strategies to market data yield better option values?"

- "which modeling approach leads to better predictions and better relative value measures?"

I think you want to ask 1 and I think it is similar to Setting the r in put-call parity? The variables C, P, S, and T−t are directly observable in the market place and contract definition. r is unobservable and it will definitely affect a deep ITM put holder's optimal early exercise strategy.

Likewise here, I think which model you use depends on your purpose. Both model has its merit and application.

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