Anatomy of an ARM: Index Dynamics and Adjustable Rate Mortgage Valuation.

This paper analyzes the dynamics of the commonly used indices for Adjustable Rate Mortgages, and systematically compares the effects of their time series properties on adjustable rate mortgage prepayment and value. Our ARM valuation methodology allows us simultaneously to capture the effects of the dynamics of the index, discrete coupon adjustment, and caps and floors. It allows us either to calculate an optimal prepayment strategy for mortgage holders, or to use an empirical prepayment function. We find that the dynamics of the ARM indices, including both their average levels and their speeds of adjustment to interest rate shocks, introduce significant variation in the value of the prepayment option across ARMs. Valuation methodologies that ignore the time series properties of the index with respect to current rates will therefore systematically misprice adjustable rate mortgages.