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Anatomy of an ARM: The Interest-Rate Risk of Adjustable-Rate Mortgages

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  • Stanton, Richard
  • Wallace, Nancy

Abstract

This article analyzes the dynamics of the commonly used indices for adjustable rate mortgages and systematically compares the effects of their time-series properties on the interest-rate sensitivity of adjustable-rate mortgages. Our ARM valuation methodology allows us simultaneously to capture the effects of index dynamics, discrete coupon adjustment, mortgage prepayment, and both lifetime and periodic caps and floors. We can, moreover, either calculate an optimal prepayment strategy for mortgage holders or use an empirical prepayment function. We find that the different dynamics of the major ARM indices lead to significant variation in the interest-rate sensitivities of loans based on different indices. We also find that changing assumptions about contract features, such as loan caps and coupon reset frequency, has a significant, and in some cases unexpected, impact on our results. Copyright 1999 by Kluwer Academic Publishers

Suggested Citation

  • Stanton, Richard & Wallace, Nancy, 1999. "Anatomy of an ARM: The Interest-Rate Risk of Adjustable-Rate Mortgages," The Journal of Real Estate Finance and Economics, Springer, vol. 19(1), pages 49-67, July.
  • Handle: RePEc:kap:jrefec:v:19:y:1999:i:1:p:49-67
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    Citations

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    Cited by:

    1. John Y. Campbell & João F. Cocco, 2003. "Household Risk Management and Optimal Mortgage Choice," The Quarterly Journal of Economics, Oxford University Press, vol. 118(4), pages 1449-1494.
    2. John Y. Campbell, 2006. "Household Finance," Journal of Finance, American Finance Association, vol. 61(4), pages 1553-1604, August.
    3. Yevgeny Mugerman & Moran Ofir & Zvi Wiener, 2016. "How Do Homeowners Choose Between Fixed and Adjustable Rate Mortgages?," Quarterly Journal of Finance (QJF), World Scientific Publishing Co. Pte. Ltd., vol. 6(04), pages 1-21, December.
    4. Brahima Coulibaly & Geng Li, 2009. "Choice of Mortgage Contracts: Evidence from the Survey of Consumer Finances," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 37(4), pages 659-673.
    5. Gathergood, John & Weber, Jörg, 2017. "Financial literacy, present bias and alternative mortgage products," Journal of Banking & Finance, Elsevier, vol. 78(C), pages 58-83.
    6. Ruben Cox & Dirk Brounen & Peter Neuteboom, 2015. "Financial Literacy, Risk Aversion and Choice of Mortgage Type by Households," The Journal of Real Estate Finance and Economics, Springer, vol. 50(1), pages 74-112, January.
    7. 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.
    8. Jane Dokko & Brian M. Doyle & Michael T. Kiley & Jinill Kim & Shane Sherlund & Jae Sim & Skander Van Den Heuvel, 2011. "Monetary policy and the global housing bubble," Economic Policy, CEPR;CES;MSH, vol. 26(66), pages 233-283, April.
    9. Svenstrup, Mikkel, 2003. "Valuation of Path-Dependent Interest Rate Derivatives in a Finite Difference Setup," Finance Working Papers 02-21, University of Aarhus, Aarhus School of Business, Department of Business Studies.
    10. Hancock, Diana & Passmore, Wayne, 2016. "Cost of funds indexed mortgage contracts with government-backed catastrophic insurance (COFI-Cats): A realistic alternative to the 30-year fixed-rate mortgage?," Journal of Economics and Business, Elsevier, vol. 84(C), pages 109-130.
    11. Svenstrup, Mikkel, 2002. "Mortgage Choice - The Danish Case," Finance Working Papers 02-22, University of Aarhus, Aarhus School of Business, Department of Business Studies.

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