Abstract
The study develops a model from which a bivariate binomial approach is utilized for pricing individual mortgage servicing contracts. The pricing model is comprised of a stochastic interest rate process and stochastic housing price process, prepayment and default functions of borrowers and an assumed servicing cost, all of which jointly determines the contract’s future net cash flows and the rate at which to discount these cash flows. Then a scenario analysis is employed to examine a myriad of risk exposures of servicing contracts under various economic environments. The implication of this paper is potentially useful for mortgage servicers to investigate the policy-related issues. The results indicate: (1)The lower the interest rate volatility, the higher will be the price of a MSR.(2)The higher the housing price volatility, the lower will be the price of a MSR.(3)The larger the speed of the adjustment factor, the length of time for varying interest rate is short. The price of a MSR increases when the adjustment factor is big. (4)Imposing the penalty associated with delinquency and deficiency judgment reduce the likelihood of delinquency, thereby increasing the value of MSR.