The Effect of Mortgage Price and Default Risk
on Mortgage Spreads
JAMES B. KAU
University of Georgia, Athens, GA, USA
LUKE C. PETERS
Bank of America, Charlotte, NC, USA
Variations over time in mortgage yield spreads should reﬂect changes in the underlying prepayment option
value; moreover, the relationship between mortgage yield spreads and interest rate dynamics should weaken as
the value of the borrower’s prepayment option declines. We verify this hypothesis through an empirical analysis
of residential mortgage yield spread behavior, and we also present evidence that the strength of the relationship
between mortgage spreads and interest rate dynamics weakens (strengthens) as the level of default risk
increases (decreases). This result is consistent with the Bcompeting risks^ effect between a borrower’s option to
prepay or default. Our results demonstrate the importance of accounting for mortgage price discount to par as
well as default risk when developing time series of mortgage yields.
Key Words: mortgage spreads, call option, points, yield curve dynamics
The views expressed herein are those of the authors and do not necessarily reﬂect the
views of Bank of America.
The fundamental relationship between prepayment risk, default risk and mortgage
valuation can be theoretically characterized in a contingent-claims-based framework
based on the option-pricing theory developed by Black and Scholes (1973) and Merton
(1974). This option-pricing framework has been applied to the valuation of numerous
types of debt instruments. Black and Cox (1976), Geske (1977), Longstaff and Schwartz
(1995) and many others apply the framework to analyze the effects of default risk on
bond value, while other researchers such as Brennan and Schwartz (1977), Dunn and
McConnell (1981) and Buser et al. (1990) theoretically characterize the effects of call
risk, exclusive of default risk, on bond valuation.
Numerous researchers have conducted empirical analyses designed to test the
implications of the theoretical bond valuation literature. Titman and Torous (1989) and
Longstaff and Schwartz (1995) empirically examine the impact of varying interest rates
The Journal of Real Estate Finance and Economics, 30:3, 285–295, 2005
2005 Springer Science + Business Media, Inc. Manufactured in The Netherlands.