Rational Valuation Model for CMOs Under Real Estate Price and Interest Rate Uncertainty

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The purpose of this research project is to build a rational valuation model for CMOs where both real estate prices and interest rates change stochastically.After I started this project, I have realized that it is necessary to investigate in detail how real estate prices affect refinancing and default in order to build a more meaningful model. In the preceding literature on mortgage-backed securities that employ an option-theoretic framework, real estate prices affect MBS prices through default that occurs if the price of a real estate property underlying the loan in question falls below the principal of the mortgage loan. Yet, a close analysis of simulation results in Kau et al., "A Generalized Valuation Model for Fixed-Rate Residential Mortgages," Journal of Money, Credit, and Banking, 24(3),279-299, indicates that the total value of the mortgage and the accompanying insurance against default is insensitive to changes in real estate prices because the value of the insurance changes accordingly. Rather, the constraint that the mortgagor cannot refinance if the underlying real estate property value falls below a certain percentage of the mortgage principal may play a more significant role in refinancing of mortgage loans.Therefore, this year I have examined some of the papers I had read last year focusing on the above point and gathered more papers to investigate this point. Based on this examination of the existing literature, I have devised new boundary conditions for refinancing to improve the CMO model that I have worked out last year.