Pricing Rate Caps on Default-Free Adjustable-Rate Mortgages

23 Pages Posted: 25 Jun 2004 Last revised: 4 Mar 2021

See all articles by Stephen A. Buser

Stephen A. Buser

Ohio State University (OSU) - Department of Finance

Patric H. Hendershott

University of Aberdeen - Centre for Property Research; National Bureau of Economic Research (NBER)

Anthony B. Sanders

George Mason University - School of Business

Date Written: December 1984

Abstract

A model is developed and utilized in this paper to value a life of loan interest rate cap on an ARM that reprices monthly. The value of the cap is seen to depend importantly on both the slope of the term structure and the variance of the one month rate. However, the cap value is not sensitive to the source of the slope of the term structure -- what precise combination of interest rate expectations and risk aversion determined the slope. This insensitivity is fortunate because of the great difficulty of knowing at any point in time why the term structure is what it is. Given the variation in the slope of the term structure and the variance of the one month rate that occurred over the 1979-84 period, the addition to the coupon rate on a one-month ARM that lenders should have charged for a 5 percent life of loan cap has ranged from 5 to 40 basis points.

Suggested Citation

Buser, Stephen and Hendershott, Patric H. and Sanders, Anthony Bown, Pricing Rate Caps on Default-Free Adjustable-Rate Mortgages (December 1984). NBER Working Paper No. w1525, Available at SSRN: https://ssrn.com/abstract=336286

Stephen Buser

Ohio State University (OSU) - Department of Finance ( email )

2100 Neil Avenue
Columbus, OH 43210-1144
United States
614-292-5719 (Phone)

Patric H. Hendershott (Contact Author)

University of Aberdeen - Centre for Property Research ( email )

Aberdeen AB24 2UF
Scotland

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Anthony Bown Sanders

George Mason University - School of Business ( email )

Fairfax, VA 22030
United States

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