WHY DO WE HAVE ARMS

This paper suggests a resolution to the paradox of inefficient risk be aring by adjustable-rate mortgage (ARM) borrowers. The analysis shows that when con tracts are written in a realistic way, with payments lin ked across time via a common loan-rate function, risk sharing and the tilt of the mortgage payment stream become inextricably linked. Unless time preferences are identical or the cost of funds exhibits no time trend, borrowers will accept interest-rate risk in order to gain a mor e favorable time path of mortgage payments.