Option pricing model for cash rebate mortgages
| Published date | 01 August 2003 |
| Date | 01 August 2003 |
| DOI | https://doi.org/10.1108/14635780310483610 |
| Pages | 307-325 |
| Author | Eddie Lam |
| Subject Matter | Property management & built environment |
Cash rebate
mortgages
307
Journal of Property Investment &
Finance
Vol. 21 No. 4, 2003
pp. 307-325
#MCB UP Limited
1463-578X
DOI 10.1108/14635780310483610
Option pricing model for cash
rebate mortgages
Eddie Lam
CITIC Ka Wah Bank and Korea Mortgage Corporation, Hong Kong
Keywords Interest rates, Pricing policy
Abstract This paper alters the traditional model of valuation by introducing trinomial trees,
and determines the difference between the traditional plain-vanilla, adjustable-rate mortgages
and cash rebate mortgages. By presenting an economic model for studying the combined effects of
mortgage value by prepayment, delinquency, default, and cure speed, the model builds a
simulation program to generate different cash flow scenarios. The results indicate that the value
of cash rebate mortgages is higher than that of standard mortgages, although they are more
sensitive to embedded options. If the probability of exercising an option is higher, then the value of
cash rebate mortgages will drop at a faster rate than that of standard mortgages.
Introduction
Hong Kong housing and mortgage market
In terms of the Asian market, Hong Kong is one of the most developed markets
in the area of housing and mortgage financing among South East Asian
countries. The outlook of Hong Kong is stable, supported by a strong liquidity
position and the absence of protracted fiscal imbalances. Standard and Poor's
gives Hong Kong's long-term foreign currency rating as A+ and Moody gives
it an A3 rating.
The housing market of Hong Kong is fluctuating. The property price of
Hong Kong increased drastically in the past ten years to the peak level of 1997,
and went down by more than 50 per cent to the low side in the past three years.
Since the depreciation of property price, the transaction volume became solid
and the interest of home buyers appears tapering off in recent years due to the
uncertainty of the economy.
The performance of the property market is poor since the downward trend
from 1997. The following are some reasons for the poor performance of the
property market in Hong Kong:
.Unfavorable economic climate ± Hong Kong is still on the edge of
recession. Since the occurrence of the Asian crisis in 1997, Hong Kong is
facing a series of problems such as declining export, deflation and
negative GDP growth, etc.
.Unemployment concerns ± due to the slowdown of the economy, the
unemployment rate has increased continuously and the real wage has
decreased.
.Caution buying sentiment ± many potential homebuyers are adopting a
wait-and-see approach, as they do not expect a sharp rebound in
property prices in the near term.
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.Large number of negative equity homeowners ± many homeowners have
suffered significant losses to the value of their properties and will not
consider buying new properties in the coming future.
.New supply overhang ± There is still a lot of unsold inventory from many
new developers.
Although there are various negative factors in the property market of Hong
Kong, positive sentiments still exist such as low mortgage rate, improving
affordability and government subsidy schemes. Definitely, the future of
property recovery will depend on the speed at which the economy recovers and
the decline of the unemployment rate in the coming future.
The residential mortgage market is large and important to the banking
industry of Hong Kong. According to statistics from the Hong Kong Monetary
Authority (HKMA), the quasi-central bank of Hong Kong, the outstanding
balance of residential mortgage loans in March 2002 was HK$541,872m
(US$69,471m), which contributed 30 per cent of the total loan and advance for
use in Hong Kong. The average size per new originated mortgage was about
HK$1.38 million (US$0.18m), the average contractual life was 225 months and
99 per cent of loans were related to owner-occupied properties. The proportion
of new approvals for transactions in the primary market, secondary market
and refinancing loans was 43.4 per cent, 37.8 per cent and 17.8 per cent,
respectively.
Except for standard mortgages, mortgage insurance is popular in Hong
Kong for those loan-to-valuation from 70 per cent to 90 per cent. The first
mortgage insurance program (MIP) was launched by the Hong Kong Mortgage
Corporation which provides an effective market solution to reduce the
downpayment of homebuyers without exposing the banks to additional risks.
Under the MIP, the Hong Kong Mortgage Corporation provides insurance cover
at a fee to the approved sellers for an amount up to 20 per cent of the property
value, which allows the banks to lend up to 90 per cent loan-to-valuation (LTV)
ratio without taking additional risk. The Hong Kong Mortgage Corporation
hedges the exposure of the mortgage insurance by taking out reinsurance with
the approved reinsurers.
Although the property price is dropped by more than 50 per cent, residential
mortgage loans in Hong Kong are of high quality. According to the statistics
from the Hong Kong Monetary Authority in 2001, the average loan-to-valuation
ratio is at a prudent level of 66 per cent, which provides a sizeable cushion to
absorb corrections in property prices. Moreover, most banks generally adopt a
prudent approach towards the disposal of repossessed properties of default
mortgages. There were a total of 3,307 repossessed properties valued at
HK$13,000m (US$1,667m), and 2,539 properties valued at HK$6,000m
(US$769m) were in the process or being repossessed in 2000. This indicates that
sales of repossessed properties accounted for only 3 per cent to total mortgage
portfolio, and that the banks were able to accelerate the disposal of repossessed
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