RT Journal Article SR Electronic T1 Prepayment Option and the Interest Rate Differential
Between a Fixed- and Floating-Rate Mortgage Loan JF The Journal of Fixed Income FD Institutional Investor Journals SP 83 OP 91 DO 10.3905/jfi.2016.25.4.083 VO 25 IS 4 A1 Jyh-Bang Jou A1 Tan (Charlene) Lee YR 2016 UL https://pm-research.com/content/25/4/83.abstract AB A fixed-rate borrower has the option to pay off the loan after paying certain penalties. The borrower will do so only if the spot interest rate falls sufficiently below the contract rate. Assuming that the spot interest rate follows a mean-reverting process, this article finds that the fixed-rate borrower has a more valuable prepayment option such that the interest rate differential between a fixed- and a floating-rate loan expands when the term of the loan lasts longer, either the steady-state or initial spot interest rate is lower, penalties associated with prepayment are lower, or interest rates increase at an unpredictable rate.TOPICS: Fixed income and structured finance, options