« Light Rail North-South routing for Saint Louis City | Main | Landholders, Residential Land Conversion, and Market Signals »

The Complexities of Mortgage Options (Prendergast)

Mortgage option prices behave quite differently than the prices of
options on underlying securities that do not exhibit significant
convexity. As a result, the intuition of many market participants
about option risk characteristics does not typically apply to
mortgage options.

The risk characteristics of these options: negative convexity of
the underlying mortgage and the positive gamma of the option
impact call option convexity in opposing directions. As a result,
call option convexity can be either positive or negative,
depending on the interest rate scenario and option specification.

On the other hand, a mortgage put option is always positively convex.
A quantitative understanding of these risk characteristics is critical
for money managers and broker/dealers who use mortgage options.

The Complexities of Mortgage Options
Prendergast, Joseph R.
March 2003

Post a comment

(If you haven't left a comment here before, you may need to be approved by the site owner before your comment will appear. Until then, it won't appear on the entry. Thanks for waiting.)