Abstract
A foreign currency mortgage is debt for the purchase of residential property denominated in foreign currency. The borrower makes monthly payments in foreign currency. Devaluation of the domestic currency results in higher monthly payments. Practitioners have proposed solutions to avoid mortgage default. However, many of the practitioner solutions place excessive financial burdens on foreign lenders, while relieving domestic borrowers of responsibility. The goal of this paper is to present a solution that shares responsibility equitably between borrowers and lenders. First, we evaluate practitioner solutions by placing them in theoretical models. Then, the paper presents a solution, in which mortgages (loans) are viewed as derivatives (not loans). This is innovative, in that it takes mortgages out of banking and places them within investments. We recognize that investors have differential attitudes to risk. Accordingly, the proposed solution is presented in two contexts, i.e. from the perspective of a risk averse investor who shuns risk, or a risk taker, who is willing to take excessive risk to pursue returns. In the proposed solution, a call buyer may exercise the option, purchasing a futures contract to obtain the currency at a strike price that is less than the spot exchange rate. During the lengthy, uncertain delivery period, the exchange rate may vary more than the immediate period defined by the spot rate, in the form of jump diffusion models with stochastic volatility. The call buyer may purchase foreign currency at a strike price equal to the forward rates of a series of 1-period futures contracts with total life equal to the life of the mortgage. As strike prices continue to increase, with domestic currency depreciation, a repayment vehicle in the form of a portfolio of high-yielding securities is proposed, to produce the funds needed to meet forthcoming increases in monthly payments.
Highlights
Beginning in 2007-2008, residents of countries in Central and Eastern Europe acquired mortgages in the Swiss Franc at lower interest rates than the interest rates offered by their home country banks
We present a solution to defaults from rising mortgage payments by removing foreign currency mortgages from bank lending to earning investment returns
The line of aberrancy is a secant line which we present as tangent to the jump diffusion curve of prices of the foreign currency. [39] jump diffusion model is employed, with risky options on foreign currency prices varying sharply in jumps from 1 period to the
Summary
Beginning in 2007-2008, residents of countries in Central and Eastern Europe acquired mortgages in the Swiss Franc at lower interest rates than the interest rates offered by their home country banks Such foreign currency mortgages subsequently proved to be excessively risky in that the depreciation of domestic exchange rates increased monthly payments by about 10% in three months. The remainder of this paper is organized as follows: Section 2 is a Review of Literature with a description of Macroeconomic Determinants of Exchange Rates, Background of Foreign Currency Mortgages and Underlying Theories, and the Distribution of Options on Currency Futures, Section 3 is an Examination of Existing Solutions to Stabilizing Mortgage Payments in Foreign Currency, Section 4 is the Proposed Solution along with an Alternative Solution, while Section 5 describes Conclusions. The rise in prices of both exports and nontradables results in an increase in currency values, ceteris paribus. [19] empirically justified this model for the United Kingdom, Austria, Switzerland, Denmark, and Italy from 1999-2007. [20] attribute the appreciation of the yen to the dollar largely to Japan’s trade surplus with the United States. [21] observed that an unfavorable external trade balance and decline in foreign reserves depleted the current account to the point of continuously declining currency values, for a Romanian sample from 2007-2011
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