Anatomy of an ARM: The interest-rate risk of adjustable-rate mortgages

This article analyzes the dynamics of the commonly used indices for adjusta ble rate mortgages and systematically compares the effects of their time-se ries properties on the interest-rate sensitivity of adjustable-rate mortgag es. Our ARM valuation methodology allows us simultaneously to capture the e ffects of index dynamics, discrete coupon adjustment, mortgage prepayment, and both lifetime and periodic caps and floors. We can, moreover, either ca lculate an optimal prepayment strategy for mortgage holders or use an empir ical prepayment function. We find that the different dynamics of the major ARM indices lead to significant variation in the interest-rate sensitivitie s of loans based on different indices. We also find that changing assumptio ns about contract features, such as loan caps and coupon reset frequency, h as a significant, and in some cases unexpected, impact on our results.