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Intensity-based framework and penalty formulation of optimal stopping problems

Authors Dai, Min
Kwok, Yue Kuen View this author's profile
You, Hong
Issue Date 2007
Source Journal of economic dynamics & control , v. 31, (12), 2007, DEC, p. 3860-3880
Summary Financial derivatives commonly contain premature termination clauses, which are embedded rights held by the holder or writer. Well known examples of these stopping rights include the early exercise right in American options, the callable right in callable securities and the prepayment right in mortgage loans. In this paper, we show how to model the mortgagor's prepayment in mortgage loans and the issuer's call in the American warrant as an event risk using the intensity based approach, where the propensity of prepayment or calling is modeled by the intensity of a Poisson process. We illustrate that the corresponding pricing formulation resembles the penalty approximation approach commonly used in the solution of the linear complementarity formulation of an optimal stopping problem. We obtain several theoretical results on the prepayment strategies of mortgage loans and calling policies of American warrants. We also propose robust second order accurate numerical schemes for solving the penalty formulation of an optimal stopping problem. (C)2007 Elsevier B.V. All rights reserved.
ISSN 0165-1889
Rights Journal of Economic Dynamics and Control © copyright (2007) Elsevier. The Journal's web site is located at'
Language English
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