ARM WRESTLING - VALUING ADJUSTABLE RATE MORTGAGES INDEXED TO THE 11TH-DISTRICT COST OF FUNDS

This article analyzes adjustable rate mortgages (ARMs) based on the El eventh District Cost of Funds Index (EDCOFI), The behavior of EDCOFI w as examined over the period 1981-1993. Adjustments in this index lag s ubstantially behind term structure fluctuations. Also, the seasonality and days-in-the-month effects noted by previous authors are really sy mptoms of a January effect. A finite difference valuation algorithm wa s developed which accounts for all usual ARM contractual features, in addition to the dynamics of EDCOFI. This pricing algorithm allows us t o determine endogenously the optimal prepayment strategy for mortgage holders, and hence the value of their prepayment options. The dynamics of EDCOFI give significant value to this option, typically around 0.5 % of the remaining principal on the loan.