A note on applying option pricing theory to emerging mortgage and mortgage-backed securities markets

Abstract

Option-based models have been the dominant paradigm for researches on the risks and pricing of mortgages and Mortgage-Backed Securities (MBS) in the USA. However, the adaptability and flexibility of option-based models in the emerging mortgage markets has been obviously neglected. This study provides the first analysis of the potential strengths and weaknesses of application of the option pricing theory to emerging markets with referring to both theoretical and empirical literatures. This study finds that the mortgage type, the attitude of mortgagees to risk and the institutional features are the key determinants of success of application of the option pricing theory to emerging mortgage and MBS markets. The option pricing literature in finance has been extended to study the risks and pricing of mortgages and MBS in the USA over the last three decades. However, given the robust and rapid growth of emerging mortgage and mortgage-related capital markets, there is surprisingly little known about to what extent the option pricing theory can be applied to the emerging mortgage and MBS markets in the global arena. The purpose of this study is to fill this gap by analysing the potential strengths and weaknesses of application of the option pricing models to emerging markets with specifically referring to both theoretical and empirical literatures.