We provide empirical evidence that quoted secondary market mortgage yields conform to the predictions of option theory. We compare Fannie Mae and Freddie Mac origination yields offered in the secondary market from 1985 to 2003 with the predictions of a two-state binomial mortgage option valuation model. Our two-state approach considers a mean-reverting interest rate process as well as a stochastic housing price. Using predictions from option simulations, we find strong links between market practice and mortgage option prepayment and default factors over time. We also find cross-sectional differences that are consistent with the institutional structure of the markets.
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