INFLATION RISK, PAYMENT TILT, AND THE DESIGN OF PARTIALLY INDEXED AFFORDABLE MORTGAGES

This paper integrates two fundamentally important parameters into a th eory of optimal mortgage design: the proportion of inflation risk born e by the lender/investor and the borrower and the amortization-graduat ion schedule for loan repayments. Equations are derived for a family o f innovative mortgages, termed hybrid PLAMs, which offer advantages to borrowers and lenders over either the standard fixed rate mortgage (F RM) or the price level adjusted mortgage (PLAM). The superiority of th e hybrid PLAMs lies in their ability to simultaneously and independent ly accommodate differing degrees of inflation-risk sharing and payment affordability. Inflation-risk sharing is represented by an indexation parameter set over a continuum of values such that the FRM has zero i ndex variability and the PLAM has unit index variability. Similarly, p ayment tilt is represented by a tilt parameter such that the FRM has z ero tilt and the PLAM has unit tilt. We demonstrate that these two par ameters are independent and can each be continuously varied in a two-d imensional family of self-amortizing mortgages. A specific hybrid PLAM can be designed to partition inflation risk in any proportion between the borrower and the lender and to simultaneously prescribe any level of payment tilt between the extremes of the FRM and PLAM. The behavio r of representative hybrid PLAMs is simulated and compared to FRMs and PLAMs for three different inflation scenarios, one of which uses actu al market data from the period of 1960-1990.