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ARM Wrestling: Valuing Adjustable Rate Mortgages Indexed to the Eleventh District Cost of Funds
Author(s) -
Stanton Richard,
Wallace Nancy
Publication year - 1995
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 - 10.1111/1540-6229.00667
Subject(s) - prepayment of loan , economics , eleventh , valuation (finance) , actuarial science , value (mathematics) , index (typography) , loan , principal (computer security) , econometrics , financial economics , finance , mathematics , statistics , computer science , physics , world wide web , acoustics , operating system
This article analyzes adjustable rate mortgages (ARMs) based on the Eleventh District Cost of Funds Index (EDCOFI). The behavior of EDCOFI was examined over the period 1981–1993. Adjustments in this index lag substantially behind term structure fluctuations. Also, the seasonality and days‐in‐the‐month effects noted by previous authors are really symptoms of a January effect . A finite difference valuation algorithm was developed which accounts for all usual ARM contractual features, in addition to the dynamics of EDCOFI. This pricing algorithm allows us to determine endogenously the optimal prepayment strategy for mortgage holders, and hence the value of their prepayment options. The dynamics of EDCOFI give significant value to this option, typically around 0.5% of the remaining principal on the loan.