PT - JOURNAL ARTICLE AU - Andrew L. Brunson AU - James B. Kau AU - Donald C. Keenan TI - A Fixed-Rate Mortgage Valuation Model in Three State Variables AID - 10.3905/jfi.2001.319289 DP - 2001 Jun 30 TA - The Journal of Fixed Income PG - 17--27 VI - 11 IP - 1 4099 - https://pm-research.com/content/11/1/17.short 4100 - https://pm-research.com/content/11/1/17.full AB - This article investigates the effect of a two-factor interest rate process on the value of the mortgage and its inherent options including the right to default. Our complete three-state model for a mortgage derivative asset is used to make comparisons with the standard two-state model with the option to default or prepay. With slight modification, this model is applicable to other types of mortgages and mortgage-backed securities, and to derivative securities in general. The authors demonstrate that a two-state model with a one-factor term structure and a three-state model with a two-factor term structure value a mortgage substantially differently. The results suggest that valuing defaultable mortgages requires a three-state option pricing model to avoid mispricing.