Valuing ARM Rate Caps: Implications of 1970–84 Interest Rate Behavior

Patric Hendershott and James D. Shilling

Real Estate Economics, 1985, vol. 13, issue 3, 317-332

Abstract: This paper computes how coupon rates on hypothetical default‐free 1‐ 3‐ and 5‐year adjustable rate mortgages with various caps and teaser rates issued during the 1970–76 period would have had to be set in order for the ARMs to have earned the market rate of return over a 7 1/2‐year holding period. The 1970–84 period includes both a relatively stable interest rate experience (1970–77) and a “worse case” sharply rising rate environment (1977–84). Thus the calculations include the entire gamut of margins that lenders might need to charge for various caps in order to earn the market rate of return. What margins lenders should be charging at any point in time depends on the relative likelihood of future interest rate paths, e.g., the 1970–77 pattern versus the 1977–84 pattern. More formally, the appropriate charge depends on the slope of the yield curve and the perceived volatility of interest rates.

Date: 1985
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