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Evaluating the Interest-Rate Risk of Adjustable-Rate Mortgage Loans

This paper evaluates the interest-rate risk inherent in an adjustable-rate mortgage (ARM) with sporadic rate adjustments and possibly binding periodic and life-of-loan rate change constraints. Simulation analysis forecasts ARM cash flows, determines the probability that constraints will hold, and partitions the loan into fixed and variable components. Simulation parameters are then altered to measure the impact of changes in contract terms and market conditions on the interest-rate risk of a typical ARM loan. Interest-rate sensitivity is found to be significantly less than that of fixed-rate loans and remarkably insensitive to changes in loan margins or initial loan rates after the first few years of an ARM's life. Therefore, it is not surprising that lenders have used these features to lure borrowers to ARMs. Periodic rate change limits and volatility in the underlying index are the only factors that influence the interest-rate risk of an existing ARM in a substantive way.

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Article provided by American Real Estate Society in its journal Journal of Real Estate Research.

Volume (Year): 13 (1997)
Issue (Month): 1 ()
Pages: 77-94

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Handle: RePEc:jre:issued:v:13:n:1:1997:p:77-94
Contact details of provider: Postal: American Real Estate Society Clemson University School of Business & Behavioral Science Department of Finance 401 Sirrine Hall Clemson, SC 29634-1323
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Order Information: Postal: Diane Quarles American Real Estate Society Manager of Member Services Clemson University Box 341323 Clemson, SC 29634-1323
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  1. James B. Kau & Donald C. Keenan & Walter J. Muller & James F. Epperson, 1990. "The Valuation and Analysis of Adjustable Rate Mortgages," Management Science, INFORMS, vol. 36(12), pages 1417-1431, December.
  2. Gary A. Anderson & Joel R. Barber & Chun-Hao Chang, 1993. "Prepayment Risk And The Duration Of Default-Free Mortgage-Backed Securities," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 16(1), pages 1-9, 03.
  3. Haensly, Paul J & Springer, Thomas M & Waller, Neil G, 1993. "Duration and the Price Behavior of Fixed-Rate Level Payment Mortgages: An Analytical Investigation," The Journal of Real Estate Finance and Economics, Springer, vol. 6(2), pages 157-66, March.
  4. Chan, K C, et al, 1992. " An Empirical Comparison of Alternative Models of the Short-Term Interest Rate," Journal of Finance, American Finance Association, vol. 47(3), pages 1209-27, July.
  5. Stephen A. Buser & Patric H. Hendershott & Anthony B. Sanders, 1985. "Pricing Life-of-Loan Rate Caps on Default-Free Adjustable-Rate Mortgages," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 13(3), pages 248-260.
  6. Brueckner, Jan K & Follain, James R, 1988. "The Rise and Fall of the ARM: An Econometric Analysis of Mortgage Choice," The Review of Economics and Statistics, MIT Press, vol. 70(1), pages 93-102, February.
  7. Cox, John C & Ingersoll, Jonathan E, Jr & Ross, Stephen A, 1985. "A Theory of the Term Structure of Interest Rates," Econometrica, Econometric Society, vol. 53(2), pages 385-407, March.
  8. Cunningham, Donald F & Capone, Charles A, Jr, 1990. " The Relative Termination Experience of Adjustable to Fixed-Rate Mortgages," Journal of Finance, American Finance Association, vol. 45(5), pages 1687-1703, December.
  9. Tucker, Michael, 1991. "Comparing Present Value Cost Differentials between Fixed- and Adjustable-Rate Loans: A Mortgage Simulation," The Financial Review, Eastern Finance Association, vol. 26(3), pages 447-58, August.
  10. Houston, Joel F & Sa-Aadu, J & Shilling, James D, 1991. "Teaser Rates in Conventional Adjustable-Rate Mortgage (ARM) Markets," The Journal of Real Estate Finance and Economics, Springer, vol. 4(1), pages 19-31, March.
  11. Dhillon, Upinder S & Shilling, James D & Sirmans, C F, 1987. "Choosing between Fixed and Adjustable Rate Mortgages: A Note," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 19(2), pages 260-67, May.
  12. Capone, Charles A, Jr & Cunningham, Donald F, 1992. "Estimating the Marginal Contribution of Adjustable-Rate Mortgage Selection to Termination Probabilities in a Nested Model," The Journal of Real Estate Finance and Economics, Springer, vol. 5(4), pages 333-56, December.
  13. Heuson, Andrea Jane, 1989. "Institutional Disparities in the Pricing of Adjustable Rate Mortgage Loans," The Journal of Real Estate Finance and Economics, Springer, vol. 2(1), pages 31-45, February.
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