Anatomy of an Arm: The Interest Rate Risk of Adjustable Rate Mortgages

Posted: 6 Dec 1998

See all articles by Richard Stanton

Richard Stanton

University of California, Berkeley - Haas School of Business

Nancy Wallace

University of California, Berkeley - Real Estate Group

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 and 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.

JEL Classification: G1

Suggested Citation

Stanton, Richard H. and Wallace, Nancy E., Anatomy of an Arm: The Interest Rate Risk of Adjustable Rate Mortgages. Journal of Real Estate Finance and Economics. Available at SSRN: https://ssrn.com/abstract=128306

Richard H. Stanton (Contact Author)

University of California, Berkeley - Haas School of Business ( email )

Haas School of Business
545 Student Services Building #1900
Berkeley, CA 94720-1900
United States
(510) 642-7382 (Phone)
(510) 643-1412 (Fax)

Nancy E. Wallace

University of California, Berkeley - Real Estate Group ( email )

Berkeley, CA 94720-1900
United States

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