Working Paper: NBER ID: w1525
Authors: Stephen A. Buser; Patric H. Hendershott; Anthony B. Sanders
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.
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Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Slope of the yield curve (E43) | Value of life-of-loan interest rate caps (E43) |
| Variance of interest rates (E43) | Value of life-of-loan interest rate caps (E43) |
| Source of the slope (C29) | Value of life-of-loan interest rate caps (E43) |