Chapter 28

Irrational Exercise of Fixed Income Options

As we continue to progress toward the mark to market of the entire balance sheet of a financial institution—and in a way that integrates interest rate risk, market risk, liquidity risk, and credit risk—we have to deal with this reality: The vast majority (by transaction count) of financial institutions’ investments are extensions of credit to individuals or small businesses whose creditworthiness is inseparable from the creditworthiness of the proprietor. Moreover, in Chapter 29, we deal with securitized pools of assets where the same problems exist.

One reason why the analysis of consumer-related financial products is so complex is the so-called “irrationality” of consumers. Perhaps the most prominent example from a Wall Street perspective is the mortgage market, which is at the heart of the 2006–2011 credit crisis. Mortgages are often prepaid when current mortgage rates are higher than the borrower’s mortgage rate, and many borrowers fail to prepay even when rates have fallen far below the rate on their loan. In the credit crisis, this was usually due to the fact that the house price had fallen so low that it was worth less than the principal on the loan. Besides these common examples of irrationality, partial prepayments are common, something that is impossible in a traditional Black-Scholes context or in the context of the fixed income options analysis we explored in Chapter 21. In both of those cases, options exercise ...

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