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Articles:
Pricing the Default Option of Inflation-Indexed Mortgages Using Explicit Finite Difference Method Authors: Işıl Erol and Kanak Patel Start Page: 48 Abstract:
This paper evaluates the default risk
of civil servants? wage-indexed payment mortgage (WIPM) contract in Turkey,
which is linked to the expected inflation. The aim of the study has two
sides: one is to apply the contingent claims approach, which has been widely
used to price standard fixed- and adjustable-rate contracts, to price an
inflation-indexed mortgage. The second is to understand if WIPM contract is
a suitable mortgage design for lenders under an inflationary economy. We
extend the traditional risk-neutral valuation for pricing the WIPM contract
with its embedded default option. Using backward pricing method, namely the
explicit finite difference method, we evaluate this unique inflation-indexed
mortgage contract from the lender?s point of view. The expected inflation
and house price are the two stochastic variables underlying the WIPM
contract. Our numerical results show that the lender benefits from
originating WIPM only during the periods when the real interest rate is very
low. Expected inflation risk premium notably increases the value of future
payments on WIPM contract, resulting in high values of lender?s position in
the mortgage agreement. The results also show that house price volatility
has a greater effect on the borrower?s default option value compared to the
expected inflation volatility. |
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