ARM Wrestling: Valuing Adjustable Rate Mortgages Indexed to the Eleventh District Cost of Funds
AbstractThis article analyzes adjustable rate mortgages (ARMs) based on the Eleventh District Cost of Funds Index (EDCOFI). The behavior of EDCOFI was examined over the period 1981-1993. Adjustments in this index lag substantially behind term structure fluctuations. Also, the seasonality and days-in-the-month effects noted by previous authors are really symptoms of a "January effect". A finite difference valuation algorithm was developed which accounts for all usual ARM contractual features, in addition to the dynamics of EDCOFI. This pricing algorithm allows us to determine endogenously the optimal prepayment strategy for mortgage holders, and hence the value of their prepayment options. The dynamics of EDCOFI give significant value to this option, typically around 0.5% of the remaining principal on the loan. Copyright American Real Estate and Urban Economics Association.
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Bibliographic InfoArticle provided by American Real Estate and Urban Economics Association in its journal Real Estate Economics.
Volume (Year): 23 (1995)
Issue (Month): 3 ()
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- Isil Erol & Kanak Patel, 2007. "Pricing the Default Option of Inflation-Indexed Mortgages Using Explicit Finite Difference Method," International Real Estate Review, Asian Real Estate Society, vol. 10(1), pages 48-92.
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- Werner Hürlimann, 2012. "Valuation of fixed and variable rate mortgages: binomial tree versus analytical approximations," Decisions in Economics and Finance, Springer, vol. 35(2), pages 171-202, November.
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