AN OPTION-THEORETIC PREPAYMENT MODEL FOR MORTGAGES AND MORTGAGE-BACKED SECURITIES

We introduce a new approach for modeling the prepayments of a mortgage pool and show how it can be used to value mortgage pools and agency mortgage-backed securities. We describe the full spectrum of refinancing behavior using a notion of refinancing efficiency. Our approach has two distinguishing features: (1) our primary focus is on understanding the market value of a mortgage, in contrast with standard models that strive (often unsuccessfully) to predict future cash flows, and (2) we use two separate yield curves, one for modeling mortgage cash flows and the other for MBS cash flows.