Default and prepayment options pricing and default probability valuation under VG model (Q2050944)

The article by Bilgi Yilmaz, A. Alper Hekimoglu and A. Sevtap Selcuk-Kestel is a valuable contribution to financial mathematics along with some its most advanced mathematical models, results and methods to address the diverse worlds of commodity markets or mortgage markets, in the presence of shocks such as the present worldwide pandemics. We may call it applied probability or stochastic calculus. This paper is mathematically and theoretically rigorous, and can become relevant practically in the future so that further investigations could be conducted and real-world applications made. These may address actuarial sciences, pension fund systems, financial markets and trades, operational research, brain research, experimental economics, and stochastic regime-switching or paradigm-shifting problem classes in game theory or optimal control. In this publication, a new approach, named as Variance Gamma (VG) model, used to capture unexpected shocks in housing markets, is proposed to the methods of option-based mortgage valuation. Such an unexpected shock may, e.g., come from a pandemic like COVID-19. Based on this VG model, for pricing mortgage default and prepayment options, closed-form solutions are provided. The authors explicitly solve the options pricing equations, and for both mortgage default and prepayment options' prices they offer numerical results. Moreover, this article enables researchers to a monitoring of mortgagors' default probability. An analysis of the risks' effect on default and prepayment options using simulations discloses that the VG model captures the idiosyncratic, i.e., systematic and systemic, risks of default and of prepayment options prices with closed-form solutions, and it calculates the probabilities of mortgage default. These contributions permit lenders for more advanced processes of decision when compared with the traditional methods of option-based mortgage valuation. This excellent article is well-written and -structured, mathematically deep and well exemplified. The six sections of this article are as follows: 1. Introduction, 2. VG process in Housing market environment and options, 3. The risk decomposition of mortgagors, 4. Option pricing using the characteristic function of the first passage time, 5. Numerical illustrations, and 6. Conclusion, followed by Appendix A. The proof of propositions, and Appendix B. Mortgage. In future, refinements and extensions analytic and stochastic theory, e.g., can be expected in the lively scientific community, prepared and accelerated by this work here. Those could be made in terms of any areas of academia and of modern economies, of modern societies and economies, in medicine and neuroscience, in environmental and geosciences, in physics and cosmology, and in the development of our peoples.