Callable Bonds and the Mortgage Prepayment Option 
Callable Bonds and the Mortgage Prepayment Option
by Yale / John Geanakoplos
Video Lecture 17 of 26
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Date Added: June 5, 2011

Lecture Description

This lecture is about optimal exercise strategies for callable bonds, which are bonds bundled with an option that allows the borrower to pay back the loan early, if she chooses. Using backward induction, we calculate the borrower's optimal strategy and the value of the option. As with the simple examples in the previous lecture, the option value turns out to be very large. The most important callable bond is the fixed rate amortizing mortgage; calling a mortgage means prepaying your remaining balance. We examine how high bankers must set the mortgage rate in order to compensate for the prepayment option they give homeowners. Looking at data on mortgage rates we see that mortgage borrowers often fail to prepay optimally.

Course Index

Course Description

This course attempts to explain the role and the importance of the financial system in the global economy. Rather than separating off the financial world from the rest of the economy, financial equilibrium is studied as an extension of economic equilibrium. The course also gives a picture of the kind of thinking and analysis done by hedge funds.

Course Structure:
This Yale College course, taught on campus twice per week for 75 minutes, was recorded for Open Yale Courses in Fall 2009.

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