Exchange-rate risk mitigation with price-level-adjusting mortgages: The case of the mexican UDI

Journal of Real Estate Research, The,  Jan-Mar 2003  by Lipscomb, Joseph B,  Harvey, John T,  Hunt, Harold

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Abstract This article is the winner of the Real Estate Finance manuscript prize (sponsored by the Fannie Mae Foundation) presented at the 2002 American Real Estate Society Annual Meeting.

In 1995, Mexico introduced a price-level-adjusting unit of account called the Unidad de Inversion (UDI). Loans denominated in UDIs maintain their purchasing power and provide a real rate of return in pesos. This study examines the real rate of return earned by dollar investors in UDI mortgages and the extent to which the inflation-adjusting aspect of the UDI mitigates losses from currency devaluations. Exchange-rate patterns relative to purchasing power parity are also examined to find investment strategies that increase the real-dollar rate of return on investments in Mexico's UDI mortgages.

Introduction

There is a housing shortage in Mexico that continues to worsen.1 A major contributing cause is insufficient capital flowing into the Mexican mortgage market. The reasons are many, including the fact that the level of income is low and sources of income are unreliable for much of the population. The infrastructure for the mortgage market is much improved in recent years but remains inadequate, which exacerbates default and liquidity risks.2 Default and inflation risks associated with long-term lending have been high in the volatile Mexican economy, which suffered from bouts of very high inflation and unemployment, and declining real wages in the 1980s and 1990s. A separate risk, exchange-rate risk, awaits foreign investors who might supply capital to the Mexican mortgage market by investing in peso-denominated mortgages. Each of these forms of risk has been reduced somewhat in recent years. The government has made an effort to reduce liquidity risk by working toward the development of a secondary mortgage market. Similarly, both default and inflation risks were reduced in 1995 when the Mexican government introduced an inflation-adjusting unit of account called the Unidad de Inversion (UDI).3

"The UDI can be thought of as a parallel currency that tracks inflation and is converted to pesos at the time of payment. This unit adjusts (in terms of pesos/ UDI) daily with inflation and can be used to price investments and loans," (Softec, 2001). Mortgage loans denominated in UDIs eliminate the risk of loss in purchasing power for lenders/investors that fund from peso sources of capital. The UDI interest rate is low relative to the peso interest rate because the UDI rate has no component for expected inflation and no risk premium for unexpected inflation. Compared to other inflation-coping mortgages available in Mexico in the recent past, UDIs lessen the likelihood of mortgage default.4

It is the purpose of this study to show that UDI mortgages also reduce exchange-rate risk for mortgage lenders/investors that have foreign capital as their source of funding. If UDI mortgages can be shown to mitigate much of the exchange-rate risk for dollar investors, the flow of capital into the Mexican mortgage market might increase and more housing will be built. The research question is to what extent does the UDI's inflation-adjusting aspect mitigate the exchange-rate risk for dollar investors and can investment strategies based on the peso's strength relative to purchasing-power-parity (PPP) lead to real-dollar returns that equal or exceed real-peso returns on UDIs? If exchange-rate mitigation is significant, there is less need to enter into hedging strategies to protect against exchange-rate losses. Moreover, if UDI mortgages provide a natural mitigation or hedge of peso risk for dollar investors, that is one less impediment to the flow of capital into the Mexican mortgage market.5

The next section describes the mechanics of UDI mortgages including an example of the UDI mortgage payment and amortization calculation. In the following section, UDI mortgages are simulated to obtain the nominal and real rates of return in both pesos and dollars using Mexico's economic data from 1982 to 1998. This is followed by an examination of changes in the real-dollar return relative to the real peso return over a 17-year period. The purchasing-power-parity between the peso and the dollar is examined in an effort to establish an investment strategy for dollar investors to further mitigate exchange-rate risk. The final section is the conclusion.

Mechanics of UDI Mortgages

The UDI mortgage calculation provides a real-rate of return for the mortgage lender/investor. As an example, assume a homebuyer borrows 250,000 pesos to purchase a house. The loan will be cast in UDIs with an interest rate of 12%, which is fixed for the 15-year term of the loan. The homebuyer contracts to borrow the UDI equivalent of 250,000 pesos. For the purposes of this example, say that one UDI is worth one peso on the day the loan is made. Thus, the borrower contracts to repay 250,000 UDIs plus 12% interest in 15 equal annual payments.6 Each payment of principal and interest is for the peso equivalent of 36,706.06 UDIs. Also for the purposes of this example, assume that inflation is 20% per year in each of the 15 years of the loan. Although the payment is fixed in terms of UDIs, the peso value of the payment changes each year with the peso/UDI conversion index that is growing at the rate of 20% per year.7