17. Callable Bonds and the Mortgage Prepayment Option

Financial Theory (ECON 251)

This lecture is about optimal exercise strategies for callable bonds, which are bonds bundled with an option that allows the borrower to pay back the loan early, if she chooses. Using backward induction, we calculate the borrower's optimal strategy and the value of the option. As with the simple examples in the previous lecture, the option value turns out to be very large. The most important callable bond is the fixed rate amortizing mortgage; calling a mortgage means prepaying your remaining balance. We examine how high bankers must set the mortgage rate in order to compensate for the prepayment option they give homeowners. Looking at data on mortgage rates we see that mortgage borrowers often fail to prepay optimally.

00:00 - Chapter 1. Introduction to Callable Bonds and Mortgage Options
12:14 - Chapter 2. Assessing Option Value via Backward Induction
42:44 - Chapter 3. Fixed Rate Amortizing Mortgage
57:51 - Chapter 4. How Banks Set Mortgage Rates for Prepayers

Complete course materials are available at the Open Yale Courses website: http://open.yale.edu/courses

This course was recorded in Fall 2009.