Journal of Applied Finance & Banking

The Least-squares Monte Carlo method for pricing options embedded in mortgages

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  •                                                    Abstract

    This paper studies the pricing problems for options embedded in fixed rate mortgages by simulation. The least-squares Monte Carlo method, which was initiated by Longstaff and Schwartz (Rev. Financ. Stud. 14(1): 113-147, 2001), is applied to price the mortgage default and prepayment options in a financial environment with two stochastic factors: house price and short term interest rate. A series of numerical comparisons for presented methods with the PDE analytical approximation method in (IAENG Int. J. Appl. Math. 39(1): 9, 2009) and the binomial tree method (BTM) (Decis. Econ. Financ. 35(2): 171-202, 2012) are given. The simulation experiments show the efficiency of presented methods and some cross-validation of the obtained simulation results are given.