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Simulation Solution to a Two-Dimensional Mortgage Refinancing Problem

Author

Listed:
  • Dejun Xie

    (South University of Science and Technology of China)

  • Nan Zhang

    (Xian Jiaotong-Liverpool University)

  • David A. Edwards

    (University of Delaware)

Abstract

This work studies a mortgage borrower’s optimal refinancing strategy, which is formulated as the solution to a stochastic minimization problem with contingent conditions. The problem is framed in a business economic environment where the underlying discounting factor and mortgage interest rate are assumed to follow a two-dimensional stochastic process of Vasicek type. A complete Monte Carlo algorithm is developed and implemented. This algorithm generates the optimal refinancing surface as a function of time and the risk-free rate. Numerical examples with financial implications are provided.

Suggested Citation

  • Dejun Xie & Nan Zhang & David A. Edwards, 2018. "Simulation Solution to a Two-Dimensional Mortgage Refinancing Problem," Computational Economics, Springer;Society for Computational Economics, vol. 52(2), pages 479-492, August.
    • Handle: RePEc:kap:compec:v:52:y:2018:i:2:d:10.1007_s10614-017-9689-1
    DOI: 10.1007/s10614-017-9689-1
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    References listed on IDEAS

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    1. Dunn, Kenneth B & McConnell, John J, 1981. "A Comparison of Alternative Models for Pricing GNMA Mortgage-Backed Securities," Journal of Finance, American Finance Association, vol. 36(2), pages 471-484, May.
    2. Vasicek, Oldrich, 1977. "An equilibrium characterization of the term structure," Journal of Financial Economics, Elsevier, vol. 5(2), pages 177-188, November.
    3. Francis A. Longstaff, 2004. "Optimal Recursive Refinancing and the Valuation of Mortgage-Backed Securities," NBER Working Papers 10422, National Bureau of Economic Research, Inc.
    4. Andrew H. Chen & David C. Ling, 1989. "Optimal Mortgage Refinancing with Stochastic Interest Rates," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 17(3), pages 278-299, September.
    5. Dunn, Kenneth B & McConnell, John J, 1981. "Valuation of GNMA Mortgage-Backed Securities," Journal of Finance, American Finance Association, vol. 36(3), pages 599-616, June.
    6. James Crotty, 2009. "Structural causes of the global financial crisis: a critical assessment of the 'new financial architecture'," Cambridge Journal of Economics, Cambridge Political Economy Society, vol. 33(4), pages 563-580, July.
    7. Vasicek, Oldrich Alfonso, 1977. "Abstract: An Equilibrium Characterization of the Term Structure," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 12(4), pages 627-627, November.
    8. Lee, Pei-Ting & Rosenfield, Donald B., 2005. "When to refinance a mortgage: A dynamic programming approach," European Journal of Operational Research, Elsevier, vol. 166(1), pages 266-277, October.
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