Anatomy of an ARM: The Interest Rate Risk of Adjustable Rate Mortgages

This article analyzes the dynamics of the commonly used indices for Adjustable Rate Mortgages, and systematically compares the effects of their time series properties on the interest rate sensitivity of adjustable rate mortgages. Our ARM valuation methodology allows us simultaneously to capture the effects of index dynamics, discrete coupon adjustment, mortgage prepayment, and both lifetime and periodic caps and floors. We can, moreover, either calculate an optimal prepayment strategy for mortgage holders, or use an empirical prepayment function. We find that the different dynamics of the major ARM indices lead to significant variation in the interest rate sensitivities of loans based on different indices. We also find that changing assumptions about contract features, such as loan caps and coupon reset frequency, has a significant, and in some cases unexpected, impact on our results. The authors gratefully acknowledge helpful comments and suggestions from Kerry Back, Dwight Jaffee, Steve Leroy, Richard Meese, and seminar participants at U.C. Berkeley and the 1994 meetings of the American Real Estate and Urban Economics Association. They also acknowledge financial assistance from the Berkeley Program in Finance, from the Dean Witter Foundation, from the U.C. Berkeley Committee on Research, and from the U.C. Berkeley Center for Real Estate and Urban Economics.