Journal of Real Estate Finance and Economics, 24:3, 239±260, 2002
# 2002 Kluwer Academic Publishers. Manufactured in The Netherlands.
Frictions, Heterogeneity and Optimality in Mortgage
JAMES B. KAU
Department of Insurance, Legal Studies and Real Estate, Terry College of Business, University of Georgia,
Athens, GA 30602, USA
V. CARLOS SLAWSON, JR.
Department of Finance, E.J. Ourso College of Business, Louisiana State University, Baton Rouge, LA, 70803
The purpose of this article is to provide a uni®ed framework for incorporating frictions into a theoretical options-
pricing model (OPM) for mortgages. This article presents formulation for a frictions-adjustable mortgage model
that integrates borrower heterogeneity while simultaneously preserving prepayment and default ®nancial
decisions. Our model demonstrates the ¯exibility of the OPM by simulating separate and concurrent effects of
three categories of frictions on the mortgage and mortgage components. Researchers can use our example
formulation to determine the effects of speci®c borrower characteristics on mortgage values without destroying
the options theoretic framework.
Key Words: mortgages, transaction costs, options pricing
Mortgage researchers have developed numerous hypotheses concerning the most relevant
factors for mortgage valuation. Many of the ideas have led to new empirical tests, the
results of which are often compared to predictions from a theoretical options-pricing
model (OPM). Consequently, the studies occasionally criticize OPMs when theoretical
predictions do not hold empirically. It is true that by analyzing actual prepayment and
default data, empiricists have made notable contributions in the area of mortgage
modeling, discovering signi®cant non-®nancial variables for predicting borrower actions.
Some versions of the OPM used for comparison, however, are often only a strict form of
the OPM, leaving many questions as to the validity of any over-generalized conclusions
criticizing the usefulness of all OPMs. In fact, the vast majority of non-®nancial empirical
concerns can be applied in a manner that preserves the underlying ®nancial decisions.
Without that preservation, we learn and understand little of the ®nancial decisions
borrowers make. The frictions-adjustable OPM presented in this article is useful for
analyzing the effects of non-®nancial factors on borrower decisions while simultaneously
maintaining optimality ( pure ®nancial decisions remain the foundation).
Within a frictionless OPM such as that of Kau et al. (1992), the borrower attempts to
maximize wealth by minimizing the mortgage liability (see Kau and Keenan (1995) and
Hendershott and Van Order (1987) for reviews of the mortgage literature). The OPM
provides prepayment and default behavior insights based upon economic factors,