Arm Wrestling: Valuing Adjustable Rate Mortgages Indexed to the Eleventh District Cost of Funds
Posted: 23 Jan 1995
This paper analyzes adjustable rate mortgages (ARMs) based on the Eleventh District Cost of Funds Index (EDCOFI). We study the behavior of EDCOFI over the period 1981--1993, and find that adjustments in this index lag substantially behind term structure fluctuations. We also find that the seasonality and days-in-the-month effects noted by previous authors are really symptoms of a "January effect". Due to the lag in EDCOFI, if interest rates fall, mortgage holders may want to refinance their mortgage loans to avoid paying a coupon rate that exceeds the market rate. We develop a finite difference valuation algorithm which accounts for all usual ARM contractual features, in addition to the dynamics of EDCOFI. The advantage of our pricing algorithm over commonly used simulation strategies is that it allows us to determine endogenously the optimal prepayment strategy for mortgage holders, and hence the value of their prepayment options. We find that the dynamics of EDCOFI give significant value to this option, typically around .5\% of the remaining principal on the loan. Our algorithm permits issuers and investors in ARMs based on EDCOFI to quantify the effects of the many interacting contract features, such as reset margin, coupon rate caps and reset frequency, that determine mortgage value.
JEL Classification: G12, G13, G21
Suggested Citation: Suggested Citation