Mortgage Pricing: What Have We Learned So Far?†

Abstract

Much progress has been achieved in the valuation of call options and mortgages. Preliminary evidence suggests that the observed term structure of interest rates (the full structure, not just the end‐points) and a reasonable estimate of the volatility of spot rates is sufficient for pricing purposes. Knowledge of the precise nature of the interest‐rate process and the exact market price of interest‐rate risk, the not‐well‐identified determinants of the term structure, are not necessary for pricing. Moreover, the number of interest‐rate state variables is also of little import, again holding the term structure and rate volatility constant.