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

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  • Cinzia Baldan
  • Francesco Zen

Abstract

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.

Suggested Citation

  • Cinzia Baldan & Francesco Zen, 2009. "Embedded options in mortgages: Implementation of the "Black, Derman and Toy" model in the italian banking Industry," Banca Impresa Società, Società editrice il Mulino, issue 1, pages 161-202.
    • Handle: RePEc:mul:jqmthn:doi:10.1435/29381:y:2009:i:1:p:161-202
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