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Pricing Life‐of‐Loan Rate Caps on Default‐Free Adjustable‐Rate Mortgages

Author

Listed:
  • Stephen A. Buser
  • Patric H. Hendershott
  • Anthony B. Sanders

Abstract

A model is developed and utilized in this paper to value a life‐of‐loan interest‐rate cap on an ARM that reprices monthly. The value of the cap is seen to depend importantly on both the slope of the term structure and the variance of the 1‐month rate. However, the cap value is not sensitive to the source of the slope of the term structure — what precise combination of interest‐rate expectations and risk aversion determined the slope. This insensitivity is fortunate because of the great difficulty of knowing at any point in time why the term structure is what it is. Given the variation in the slope of the term structure and the variance of the 1‐month rate that occurred over the 1979–84 period, the addition to the coupon rate on a 1‐month ARM that lenders should have charged for a 5% life‐of‐loan cap has ranged from 5 to 40 basis points.

Suggested Citation

  • Stephen A. Buser & Patric H. Hendershott & Anthony B. Sanders, 1985. "Pricing Life‐of‐Loan Rate Caps on Default‐Free Adjustable‐Rate Mortgages," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 13(3), pages 248-260, September.
    • Handle: RePEc:bla:reesec:v:13:y:1985:i:3:p:248-260
    DOI: 10.1111/1540-6229.00353
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    Cited by:

    1. Stephen A. Buser & Patric H. Hendershott & Anthony B. Sanders, 1988. "On the Determinants of the Value of Call Options on Default-Free Bonds," NBER Working Papers 2529, National Bureau of Economic Research, Inc.
    2. Sprecher, C. R. & Willman, Elliott, 2000. "The Role of the Initial Discount in the Pricing of Adjustable-Rate Mortgages," Journal of Housing Economics, Elsevier, vol. 9(1-2), pages 64-75, March.
    3. Eddie Lam, 2002. "A Risk Management Model for MBS Issuers," International Real Estate Review, Global Social Science Institute, vol. 5(1), pages 169-195.
    4. Patric H. Hendershott & James D. Shilling, 1991. "The Continued Interest-Rate Vulnerability of Thrifts," NBER Chapters, in: Financial Markets and Financial Crises, pages 259-282, National Bureau of Economic Research, Inc.
    5. Lim, Terence & Lo, Andrew W. & Merton, Robert C. & Scholes, Myron S., 2006. "The Derivatives Sourcebook," Foundations and Trends(R) in Finance, now publishers, vol. 1(5–6), pages 365-572, April.
    6. Don M. Chance, 1994. "The Pricing And Hedging Of Limited Exercise Caps And Spreads," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 17(4), pages 561-584, December.
    7. Eduardo S. Schwartz & Walter N. Torous, 1991. "Caps on Adjustable Rate Mortgages: Valuation, Insurance, and Hedging," NBER Chapters, in: Financial Markets and Financial Crises, pages 283-304, National Bureau of Economic Research, Inc.
    8. Anthony Pennington‐Cross & Giang Ho, 2008. "Predatory Lending Laws and the Cost of Credit," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 36(2), pages 175-211, June.
    9. Sprecher, C. R. & Willman, Elliott, 1998. "The Margin Paradox in Adjustable-Rate Mortgages," Journal of Housing Economics, Elsevier, vol. 7(2), pages 180-190, June.
    10. Raymond Chiang & Thomas F. Gosnell & Andrea J. Heuson, 1997. "Evaluating the Interest-Rate Risk of Adjustable-Rate Mortgage Loans," Journal of Real Estate Research, American Real Estate Society, vol. 13(1), pages 77-94.

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