Hi, Can anybody recommend literature on applying the option pricing methods (e.g. Bermudian option to represent refinancing decisions) to modeling mortgages? Thanks, Michael

A seminal paper and a good place to start is R. Stanton (1995) "Rational prepayment and the valuation of mortgage-backed securities", Review of Financial Studies 8(3) pp 677-708 (link) and the earlier account by Schwartz and Torous having an almost identical title (link). There is some discussion whether pure rational models are capable of explaining prepayments (ie. are all factors explaining prepayments present in the models and what is the cause of the residual between predicted and observed prepayments) and whether using empirical models for prepayment behavior can be justified (ie. whether datafiddling and non-hedgeable parameters estimated on more-or-less quantitative/theoretical basis make for sound models). You may read Chapter 13 of Claus Munks Lecture Notes Fixed Income analysis: Securities, Pricing and Risk Management that provide for a recent overview of mortgage-backed bonds.

Hi Caroe:Thanks a lot! Let me digest this. We are trying to implement an "option pricing" model for mbs which includes some parameters (to be calibrated using a prepayment model) to account for the inefficiency of the refinancing decisions. Michael

for a less theoretical, more practical feel this guy is supposed to be the industry standard in the US.Andrew Davidson - prepayment models for morgages in the US.

QuoteOriginally posted by: pyatskiWe are trying to implement an "option pricing" model for mbs which includes some parameters (to be calibrated using a prepayment model) to account for the inefficiency of the refinancing decisions. MichaelI believe it is debatable whether refinancing decisions are inefficient, as you need to take into account the various issues affecting refinancing decisions: Fixed and variable fees, possible refinancing alternatives, credit and liquidity issues etc. Empirical prepayment models provide a shortcut in the sense that past information is used to assess future prepayment behavior, thereby avoiding setting up the decision problem of the mortgagor and accounting for everything that affects these decisions. Yet it may still be a viable solution to formulate the mortgagors decisions as the result of some optimization problem, se e.g. this paper by Longstaff. Past performance is no guarantee for future returns, not even for empirical prepayment models, and decision-theoretic models may be better suited when new mortgage products are introduced