The Variable-Rate Mortgage and Risk in the Mortgage Market: An Option Theory Perspective: Note

Abstract

An important public policy debate in recent years has centered around ways to reduce risks in the mortgage market. The most significant proposal in this area has been to eliminate Regulation Q and allow more widespread use of variable-rate mortgages [ 1, 4, 5, 8, 9, 10, 13] . The purpose of this paper is to analyze the nature of risks to thrift institutions and mortgagors. In this regard we find that the framework of the theory of options provides considerable insight into this problem and its possible solutions. A variable-rate mortgage (VRA1) is a long-term mortgage loan contract that carries an effective rate that changes periodically in sympathy with market rates of interest [4, 9]. This change can be implemented by a variation in the monthly mortgage payment (variable payment), a variation in the number of fixed monthly payments (variable maturity), or both; our discussion will employ the second.l A savings and loan association (SL 2. denomination intermediation (joining mostly small deposits with large mortgages); 3. default risk intermediation (joining less risky deposits with more risky mortgages); 4. maturity intermediation (joining short-term deposits with fixed-rate mortgages); 5. interest rate intermediation (joining variable-rate deposits with fixed-rate mortgages). The policy issue under debate currently involves allowing S&Ls to market residen-