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

    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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