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

Raymond Chiang, Thomas F. Gosnell () and Andrea J. Heuson ()
Additional contact information
Raymond Chiang: Finance Department Chinese University of Hong Kong K. K. Leung Building Room 224 Shatin, TN Hong Kong, http://www.cuhk.edu.hk/fin/index.html
Thomas F. Gosnell: Department of Finance College of Business Oklahoma State University Stillwater, Oklahoma 74078, http://www2.bus.okstate.edu/fin/dept/index.html
Andrea J. Heuson: Finance Department University of Miami P.O. Box 248094 Corel Gables, Florida 33124, http://www.bus.miami.edu/fin/

Journal of Real Estate Research, 1997, vol. 13, issue 1, pages 77-94

Abstract: 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.

JEL-codes: L85 (search for similar items in EconPapers)
Date: 1997
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