| Abstract: |
We use a contingent claims framework for valuing the default and prepayment
embedded options in certain British fixed-rate endowment mortgages, with a (capped)
mortgage indemnity guarantee (MIG). This methodology provides a template for the
borrower, lender and insurer to compare mortgage terms, including the fairness of
contract rates, arrangement fees, prepayment penalties, any MIG premiums required, and
co-insurance exposure. With empirical inputs, this model may eventually be useful as a
"mark-to-value" proxy for all parties, as expected parameters change (especially interest
rate and house price levels, and expected future volatilities), for purposes of determining
"valued added accounting", appropriate reserves, and indeed for setting premiums and
business drivers.
Fixed rate endowment mortgages differ from fixed rate repayment mortgages
primarily because, in the event of early termination, the amount owed by the borrower
is a function of the evolution of the term structure of interest rates, whereas for a repayment
mortgage it is pre-determined. We compare endowment and repayment mortgages for
different levels of loan-to-value ratios, interest rate and house price volatilities.
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