Evaluating the interest-rate risk of adjustable-rate mortgage loans

Journal of Real Estate Research, The,  1997  by Raymond Chiang,  Thomas F Gosnell,  Andrea J Heuson

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The top two panels in Exhibit 2 also demonstrate how changes in margins and teasers impact the expected yield or return to the mortgage lender. Logically, expected yield rises as the margin rises or the teaser falls. The relative impact of each change highlights an additional result of recent ARM lender behavior.

Note that yield decrease suffered as the teaser rises is much smaller than the yield increase earned when the margin increases by an identical amount. This result occurs because the margin affects all of the future ARM cash flows while the impact of the teaser is felt only in the early years. Thus, results suggest that lenders who trade lower teasers for higher margins benefit from increased mortgage returns with little impact on overall interest-rate risk.

Index Volatility

Adjustments to the volatility level and the periodic rate change limit have effects that are different from those in the preceding analysis in two important ways. First, they increase the S2 and S3 (upward and downward constraint) frequencies equally. Second, they impact all years of the loan's life.

As shown in Panel C of Exhibit 2, when index volatility increases, these developments enlarge the value of the fixed-rate component and give greater relative weight to its later cash flows, increasing duration. Therefore, since the two components of total ARM duration are moving in the same direction, small increments in index volatility cause substantial increases in the interest-rate risk of an ARM loan.13 This analysis suggests that lenders should be especially concerned about protecting the value of their adjustablerate loan portfolios when short-term rates are erratic, and corroborates the findings of Kau et al. (1990, 1993) that volatility decreases the value of an ARM loan. Notice also that increased volatility decreases expected ARM returns (yield) in Exhibit 2.

Annual Rate Change Limits

As the annual rate change limit rises, Panel D of Exhibit 2 shows that the frequencies with which both upward and downward constraints hold diminish rapidly. This decreases the size of the fixed-rate component and its duration so the net effect of increased limits on the interest-rate risk of the total loan is a dramatic reduction. Expected ARM yield also rises.

Typical ARM limits moved from 1.5% to 2% early in the origination history of the loans. That effort by lenders appears to have decreased their interest-rate exposure by almost 50%. This finding is consistent with earlier work applying option pricing models to ARMs. For example, Hendershott and Shilling (1985) found that doubling an ARM's adjustment limit from 1% to 2% increased the risk-neutral required coupon rate premium from 1% to only 1.25%.

Recent History of the Adjustment Index

Simulation parameters that generated the results in Exhibits I and 2 were estimated from weekly values of the one-year constant maturity Treasury yield from 1985 to 1990. As shown in Exhibit 3, the level and volatility of the adjustment index has varied dramatically over the past decade, which raises the question of the applicability of results estimated from earlier data.