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Inflation Risk, Payment Tilt, and the Design of Partially Indexed Affordable Mortgages

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  • William H. Scott
  • Arthur L. Houston
  • A. Quang Do

Abstract

This paper integrates two fundamentally important parameters into a theory of optimal mortgage design: the proportion of inflation risk borne by the lender / investor and the borrower and the amortization-graduation schedule for loan repayments. Equations are derived for a family of innovative mortgages, termed hybrid PLAMs, which offer advantages to borrowers and lenders over either the standard fixed rate mortgage (FRM) or the price level adjusted mortgage (PLAM). The superiority of the hybrid PLAMs lies in their ability to simultaneously and independently accommodate differing degrees of inflation-risk sharing and payment affordability. Inflation-risk sharing is represented by an indexation parameter set over a continuum of values such that the FRM has zero index variability and the PLAM has unit index variability. Similarly, payment tilt is represented by a tilt parameter such that the FRM has zero tilt and the PLAM has unit tilt. We demonstrate that these two parameters are independent and can each be continuously varied in a two-dimensional family of self-amortizing mortgages. A specific hybrid PLAM can be designed to partition inflation risk in any proportion between the borrower and the lender and to simultaneously prescribe any level of payment tilt between the extremes of the FRM and PLAM. The behavior of representative hybrid PLAMs is simulated and compared to FRMs and PLAMs for three different inflation scenarios, one of which uses actual market data from the period of 1960-1990. Copyright American Real Estate and Urban Economics Association.

Suggested Citation

  • William H. Scott & Arthur L. Houston & A. Quang Do, 1993. "Inflation Risk, Payment Tilt, and the Design of Partially Indexed Affordable Mortgages," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 21(1), pages 1-25.
  • Handle: RePEc:bla:reesec:v:21:y:1993:i:1:p:1-25
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    References listed on IDEAS

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    1. Dixie M. Blackley & James R. Follain & Haeduck Lee, 1986. "An Evaluation of Hedonic Price Indexes for Thirty-four Large SMSAs," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 14(2), pages 179-205.
    2. Statman, Meir, 1982. "Fixed Rate or Index-Linked Mortgages from the Borrower's Point of View: A Note," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 17(03), pages 451-457, September.
    3. Baesel, Jerome B. & Biger, Nahum, 1980. "The Allocation of Risk: Some Implications of Fixed versus Index-Linked Mortgages," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 15(02), pages 457-468, June.
    4. Dokko, Yoon & Edelstein, Robert H, 1991. "Interest Rate Risk and Optimal Design of Mortgage Instruments," The Journal of Real Estate Finance and Economics, Springer, vol. 4(1), pages 59-68, March.
    5. John M. Harris & Daniel E. Page, 1985. "Rate Level Indexed Mortgages: An Evaluation," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 13(2), pages 195-207.
    6. Marsh, Terry A & Rosenfeld, Eric R, 1983. " Stochastic Processes for Interest Rates and Equilibrium Bond Prices," Journal of Finance, American Finance Association, vol. 38(2), pages 635-646, May.
    7. Ramaswamy, Krishna & Sundaresan, Suresh M., 1986. "The valuation of floating-rate instruments : Theory and evidence," Journal of Financial Economics, Elsevier, vol. 17(2), pages 251-272, December.
    8. Arthur L. Houston, 1988. "A Comparison of the Reinvestment Risk of the Price Level Adjusted Mortgage and the Standard Fixed Payment Mortgage," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 16(1), pages 34-49.
    9. Katherine A. Kiel & Richard T. Carson, 1990. "An Examination of Systematic Differences in the Appreciation of Individual Housing Units," Journal of Real Estate Research, American Real Estate Society, vol. 5(3), pages 301-318.
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    Cited by:

    1. 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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