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...behavioral, prepayment and default. Both classes of model are shown to be effective for evaluating innovations in contracting such as defeasance options in commercial mortgage contracts and hybrid residential mortgage products. Finally, the articles highlight a number of important methodological linkages between recent advances in mortgage modeling and those found in the valuation of other forms of risky debt such as corporate bonds.
The structural models presented here focus on pricing and modeling credit or call events that are specific to a particular class of borrower. These models focus on the underlying dynamics of interest rates and the assets that are the collateral on the mortgage. Credit (or call) events are triggered by random movements in the asset price relative to a threshold that is the exercise price on the option. By modeling credit or call events in terms of the underlying dynamics of asset prices and/or interest rates, the structural methodology functionally links option exercise events to the underlying fundamentals faced by the borrower. These articles build upon an extensive literature with a corporate debt focus: Leland (1994), Jarrow and Turnbull (1995), Longstaff and Schwartz (1995), Leland and Toft (1996), Anderson and Sundaresan (2000), Collin-Dufresne and Goldstein (2001) and Huang and Huang (2002), among many others. They also build upon important prior structural mortgage models including Dunn and McConnell (1981a,b), Timmis (1985), Johnston and van Drunen (1988), Kau et al. (1992), Stanton (1995), Kau et al. (1995) and Kau and Slawson (2002), among many others.
In contrast, reduced-form, or behavioral, approaches, do not explicitly model the value of the borrower's assets and capital structure. Instead credit and/or call events are modeled as exogenously specified jump processes or hazard rates. These approaches emphasize empirical estimation of the random timing of option exercise events. Bond valuation requires computing conditional expectations under a risk-neutral probability of functionals of event timing and realized cash flows. Recent examples of the reduced-form approaches to the valuation of corporate risky debt include Jarrow and Turnbull (1995), Duffee (1998), Duffie and Singleton (1999), Collin-Dufresne and Solnik (2001) and Duffie and Lando (2001). Schwartz and Torous (1989) develop one of the first reduced-form mortgage-backed securities (MBS) valuation models in which prepayment was modeled as a function of a set of (nonmodel based) explanatory variables. Deng, Quigley and...
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