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Optimal Sharing of Interest‐Rate Risk in Mortgage Contracts: The Effects of Potential Prepayment and Default
Author(s) -
Brueckner Jan K.,
Lee Kangoh
Publication year - 2016
Publication title -
real estate economics
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.064
H-Index - 61
eISSN - 1540-6229
pISSN - 1080-8620
DOI - 10.1111/1540-6229.12149
Subject(s) - prepayment of loan , mortgage underwriting , default risk , shared appreciation mortgage , economics , outcome (game theory) , interest rate , embedded option , fixed interest rate loan , actuarial science , mortgage insurance , monetary economics , credit risk , microeconomics , finance , casualty insurance , insurance policy
Much of the literature on the economics of mortgage markets has studied the fixed vs. adjustable‐rate mortgage choice made by individual borrowers. However, to decide if the outcome of such a choice is efficient or approximately so, it is necessary to explore the question of optimal risk‐sharing in mortgage contracts. But because only a small literature has studied this question, more research is clearly warranted. The present article helps fill this gap by developing a simplified version of Arvan and Brueckner's model, using it to characterize optimal contracts in the absence of mortgage termination, and then exploring how termination via prepayment or default affects optimal risk‐sharing. The broad conclusion of the analysis is that potential mortgage termination makes higher risk exposure for borrowers optimal.