Title

A Path-Dependent Approach To Security Valuation With Application To Interest Rate Contingent Claims

Authors

Authors

D. T. Breeden;J. H. Gilkeson

Comments

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Abbreviated Journal Title

J. Bank Financ.

Keywords

interest rate contingent claims; path-dependent pricing; embedded; options; mortgage valuation; TERM STRUCTURE; Business, Finance; Economics

Abstract

The last two decades have witnessed a tremendous growth in the volume of assets and Liabilities whose cash flows depend, in a variety of ways, on the path of interest rates. Some of these, including floating-rate notes and swap agreements, contractually base cash flows on current and past interest rates and contain caps, floors, and other, more complex features. Others, including mortgages, many corporate bonds, and time deposits, are fixed-rate instruments that contain embedded options, such as those to prepay, call, or withdrawal. The irregular exercise of these options causes cash flows to vary as time proceeds and interest rates rise or fall. This paper develops a state-contingent claims technique for valuing such securities. It is derived from the option-based model of Breeden and Litzenberger (1978) using the transition matrix approach of Banz and Miller (1978). Particular attention is paid to valuing so-called path-dependent securities whose contemporaneous cash flows depend on the historical path of interest rates as well as their current level. A detailed example is provided in which an adjustable-rate mortgage is valued under a variety of economic and security specific assumptions.

Journal Title

Journal of Banking & Finance

Volume

21

Issue/Number

4

Publication Date

1-1-1997

Document Type

Article

Language

English

First Page

541

Last Page

562

WOS Identifier

WOS:A1997WV78100006

ISSN

0378-4266

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