Cinzia Baldan, Francesco Zen

Embedded options in mortgages: Implementation of the "Black, Derman and Toy" model in the italian banking Industry

  • Abstract

Informations and abstract

Keywords: Asset & liability management, banks, fixed-rate mortgages, interest rate risk, prepayment option

We analyze the variables determining the exercise of the prepayment option in mortgages for Italian banks, by applying a specific model to measure the prepayment option in the case of refinancing option exercise. Considering a fixed-rate mortgage, we estimate a selected bank exposure's to interest rate risk. Main findings highlight that an increase in volatility causes an increase in option prices. In the case of a yield curve with a marked positive gradient, the prepayment option price exhibits high sensitivity to volatility changes. The prepayment option price can be considered a decreasing function of the credit spread and transaction costs.

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