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Modeling Behavioral Risk

Contracts with embedded prepayment/extension options are subject to behavioral risk, due to the unpredictable exercise strategy followed by the option holder. Empirical data show that, in many situations and for different reasons, investors do not act purely on the strength of financial convenience and do not take full advantage of the option owned. When seen from the viewpoint of the option seller, such behavior results in a lower option value and an additional source of uncertainty in future cash flows. In this paper, we propose a general framework to model behavioral risk by exploiting a parallel with credit risk modeling. Early redemption probabilities are assimilated to default probabilities and investor decisions to default events. Our approach is micro-structural, meaning that the aggregate prepayment rate derives from individual decisions. It also combines some features of intensity-based and option-based models, which have been reported in literature.