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A Contingent Claims Analysis of Price Level‐Adjusted Mortgages

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  • Taewon Kim

Abstract

This paper examines the performance of alternative mortgage instruments in an environment of stochastic price fluctuations. The two most widely discussed contracts that deal with inflation are the adjustable‐rate mortgage (ARM) and the price level‐adjusted mortgage (PLAM). The former compensates for inflation by paying the nominal interest rate, which contains a component reflecting the rate of inflation. Nonetheless, even without explicit nominal amortization, this results in real amortization and hence a tilting effect. In addition, the inflation component of the nominal interest rate is shown to reflect only anticipated and not actual inflation, and so the real value of an ARM fluctuates due to unanticipated inflation. A PLAM suffers from none of these defects. To the extent that one is interested in a mortgage whose properties reflect the underlying real environment, the price level‐adjusted mortgage is the ideal instrument.

Suggested Citation

  • Taewon Kim, 1987. "A Contingent Claims Analysis of Price Level‐Adjusted Mortgages," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 15(3), pages 117-131, September.
    • Handle: RePEc:bla:reesec:v:15:y:1987:i:3:p:117-131
    DOI: 10.1111/1540-6229.00423
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    References listed on IDEAS

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    1. Richard, Scott F., 1978. "An arbitrage model of the term structure of interest rates," Journal of Financial Economics, Elsevier, vol. 6(1), pages 33-57, March.
    2. Milton Friedman & Herbert Giersch & William Fellner, 1974. "Essays on Inflation and Indexation," Books, American Enterprise Institute, number 919189, September.
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    Cited by:

    1. Isil Erol & Kanak Patel, 2007. "Pricing the Default Option of Inflation-Indexed Mortgages Using Explicit Finite Difference Method," International Real Estate Review, Global Social Science Institute, vol. 10(1), pages 48-92.
    2. Erol, Isil & Patel, Kanak, 2005. "Default risk of wage-indexed payment mortgage in Turkey," Journal of Housing Economics, Elsevier, vol. 14(3), pages 271-293, September.
    3. Isil Erol & Kanak Patel, 2004. "Housing Policy and Mortgage Finance in Turkey During the Late 1990s Inflationary Period," International Real Estate Review, Global Social Science Institute, vol. 7(1), pages 98-120.

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