The effect of mortgage form on borrower interest rate risk: A portfolio theory approach

The problems faced by U.S. regulatory authorities in controlling residential housing cycles have resulted in a continuing search for methods of reducing the volatility of housing construction. One of the most widely discussed methods of decreasing volatility in mortgage credit is the variable rate mortgage (VRM) whose interest rate is linked to some interest rate index. In this paper we employ a portfolio theory approach to examine the relative riskiness of the VRM and fixed rate mortgage (FRM) for borrower and lender. As expected, we find that relative riskiness depends on the composition of the borrower/lender portfolio of assets and liabilities.