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An Empirical Test of a Two‐Factor Mortgage Valuation Model: How Much Do House Prices Matter?
Author(s) -
Downing Chris,
Stanton Richard,
Wallace Nancy
Publication year - 2005
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/j.1540-6229.2005.00135.x
Subject(s) - prepayment of loan , economics , valuation (finance) , house price , econometrics , interest rate , financial economics , actuarial science , monetary economics , finance
This article develops a two‐factor structural mortgage pricing model in which rational mortgage‐holders choose when to prepay and default in response to changes in both interest rates and house prices. We estimate the model using comprehensive data on the pool‐level termination rates for Freddie Mac Participation Certificates issued between 1991 and 2002. The model exhibits a statistically and economically significant improvement over the nested one‐factor (interest‐rate only) model in its ability to match historical prepayment data. Moreover, the two‐factor model produces origination prices that are significantly closer to those quoted in the to‐be‐announced market than the one‐factor model. Our results have important implications for hedging mortgage‐backed securities.