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Valuing ARM Rate Caps: Implications of 1970–84 Interest Rate Behavior
Author(s) -
Hendershott Patric H.,
Shilling James D.
Publication year - 1985
Publication title -
real estate economics
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.064
H-Index - 61
eISSN - 1540-6229
pISSN - 1080-8620
DOI - 10.1111/1540-6229.00357
Subject(s) - interest rate , economics , floating interest rate , forward rate , volatility (finance) , order (exchange) , coupon , econometrics , yield curve , period (music) , rate of return , financial economics , monetary economics , finance , physics , acoustics
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.