An Analysis of Variable Rate Residential Mortgage Prepayment in Hong Kong using Aggregate Data

Abstract

A distinctive feature of mortgages as assets is the existence of prepayment risk, typically viewed as a borrower’s call option to pay the outstanding mortgage balance at any time during the term. While previous research identified important causes for prepayment, these studies are mostly based on fixed-rate mortgages, with little work on variable-rate or floating-rate mortgages and even less work on prepayment in countries other than the USA. This paper presents an analysis of prepayment based on the historical aggregate pre-payment experience of a sample of variable rate mortgages in Hong Kong, which func-tions under a Currency Board Mechanism that determines exogenously the level and term structure of interest rates. With variable rate mortgages, it is expected that there will not be a prepayment incentive with decreases in interest rates, unlike the case with fixed-rate mortgages. However, we argue that observed interest rate movements remain a key factor that affects prepayment decisions, because current interest changes influence expected future interest rates. Furthermore, drawing on quasi-rational and behavioral economics concepts, we expect the effect on prepayment of expected upward movement in interest rates to be stronger than that of expected downward movements. Empirical evidence from the adjustable rate residential mortgage sample from Hong Kong supports these expected relationships.