Anatomy of an Arm: the Interest Rate Risk of Adjustable Rate Mortgages the Authors Gratefully Acknowledge Helpful Comments and Suggestions From

This article analyzes the dynamics of the commonly used indices for Adjustable Rate Mortgages, and systematically compares the eeects of their time series properties on the interest rate sensitivity of adjustable rate mortgages. Our ARM valuation methodology allows us simultaneously to capture the eeects of index dynamics, discrete coupon adjustment, mortgage prepayment, and both lifetime and periodic caps and oors. We can, moreover, either calculate an optimal prepayment strategy for mortgage holders, or use an empirical prepayment function. We nd that the diierent dynamics of the major ARM indices lead to signiicant variation in the interest rate sensitivities of loans based on diierent indices. We also nd that changing assumptions about contract features, such as loan caps and coupon reset frequency, has a signiicant, and in some cases unexpected, impact on our results.