Option pricing model for cash rebate mortgages

Abstract

This paper alters the traditional model of valuation by introducing trinomial trees, and determines the difference between the traditional plain‐vanilla, adjustable‐rate mortgages and cash rebate mortgages. By presenting an economic model for studying the combined effects of mortgage value by prepayment, delinquency, default, and cure speed, the model builds a simulation program to generate different cash flow scenarios. The results indicate that the value of cash rebate mortgages is higher than that of standard mortgages, although they are more sensitive to embedded options. If the probability of exercising an option is higher, then the value of cash rebate mortgages will drop at a faster rate than that of standard mortgages.