Behavioral Value Adjustments for Mortgage Valuation

Abstract

Behavioral risk affects the pricing of assets and liabilities with embedded pre-payment/extension options whenever the option holder does not act purely on the strength of financial convenience but follows an uncertain and sub-optimal exercise strategy, if seen from the viewpoint of the option seller. Such behavior is particularly relevant for mortgage valuation, since mortgage prepayments are clearly influenced by exogenous and individual factors besides financial reasons. In this paper we apply the general framework, proposed by Bissiri and Cogo, for modeling behavioral risk to the particular case of the valuation of a fixed-rate mortgage portfolio. We also extend the formulas by considering a pool of heterogeneous mortgagors, leading to the introduction of specific behavioral risk adjustments (βVA) in the pricing formulas.