Valuing Fixed-Income Options and Mortgage-Backed Securities with Alternative Term Structure Models Ren-Raw Chen, Brian A. Maris and Tyler T. Yang* INTRODUCTION In order to value mortgage-backed securities or options on fixed- income securities it is necessary to make some assumptions about the term structure of interest rates. In this paper, we compare the biases that alternative term structure models introduce into the valuation of mortgage-backed securities and fixed-income securities. We assume that the multi-factor fixed parameter term structure model accurately represents the actual term structure of interest rates, and the values of mortgage-backed securities and discount bond options derived from such a term structure model are correct. Differences in the prices of interest rate derivative securities obtained from alternative term structure models are therefore the result of pricing bias introduced by the term structure model. Three alternative approaches to modeling the term structure of interest rates are considered: the single-factor, fixed parameter model; the single-factor time-varying parameter model; and the multi-factor fixed parameter model. 1 The price biases that result from the use of single-factor models are compared and attributed to differences in the underlying term Journal of Business Finance & Accounting, 26(1) & (2), January/March 1999, 0306-686X ß Blackwell Publishers Ltd. 1999, 108 Cowley Road, Oxford OX4 1JF, UK and 350 Main Street, Malden, MA 02148, USA. 33 * The authors are respectively from the Department of Finance, Rutgers University; the College of Business Administration, Northern Arizona University; and Price Waterhouse, Arlington, VA. They gratefully acknowledge helpful comments from an anonymous referee. (Paper received October 1996, revised and accepted May 1998) Address for correspondence: Brian Maris, College of Business Administration, P.O. Box 15066, Northern Arizona University, Flagstaff, AZ 86011, USA. e-mail: brian.maris@nau.edu