Abstract
This paper examines the performance of alternative mortgage instruments in an environment of stochastic price fluctuations. The two most widely discussed contracts that deal with inflation are the adjustable‐rate mortgage (ARM) and the price level‐adjusted mortgage (PLAM). The former compensates for inflation by paying the nominal interest rate, which contains a component reflecting the rate of inflation. Nonetheless, even without explicit nominal amortization, this results in real amortization and hence a tilting effect. In addition, the inflation component of the nominal interest rate is shown to reflect only anticipated and not actual inflation, and so the real value of an ARM fluctuates due to unanticipated inflation. A PLAM suffers from none of these defects. To the extent that one is interested in a mortgage whose properties reflect the underlying real environment, the price level‐adjusted mortgage is the ideal instrument.
Published Version
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