Explicit formulas for pricing of callable mortgage-backed securities in a case of prepayment rate negatively correlated with interest rates (Q432394)

The authors consider the valuation of Mortgage-Backed Securities in a reduced-form modeling framework. The main feature of the valuation model is to introduce an exponential process for modeling a prepayment factor. The prepayment rate is assumed to be inversely proportional to a stochastic interest rate, where the dynamics of the interest rate are governed by a CIR process. A partial differential equation approach is used to value Mortgage-Backed Securities. In particular, explicit pricing formulas are obtained for the pass-through Mortgage-Backed Securities and semi-analytical formulas are derived for Collateralized Mortgage Obligations. Numerical examples are provided to illustrate the effects of mortgage parameters on the prices of Mortgage-Backed Securities and to explain the negative correlation between the prices of Mortgage-Backed Securities and interest rates.