Swiss variable rate mortgage, Financial Management

A Swiss Variable Rate Mortgage (SVRM) is a version of ARM which carries a coupon rate that a bank can change any time giving a notice of three month or so. This contract is allowed to be terminated by either of the parties with a notice period of three months. It is observed that the coupon rates for this instrument change in the same direction as the market rates; however, the degree to which it can change is low. The reason behind the banks not adjusting the rates with those of the market is the political pressure. Since the maximum rent that can be charged is closely related to mortgage rates, a change in coupon rate is subject to high analysis in the market. Banks are under pressure not to raise/lower their mortgage rates immediately when interest rates are increasing/decreasing. In a decreasing interest rate scenario, the banks do not lower the mortgage rates by the same amount as a decrease in interest rates in order to break even. These factors make pricing understandably a comprehensive process. One possible approach is to handle this mortgage like ARM. A prominent feature of this mortgage is that prices need not be equal to the face value. Further, the interest rate process determines whether the mortgage is valued above or below a hundred. However, the lowering or increasing the floating rate of ARM will not have a symmetric effect on the value of the mortgage. Since the coupon rates do not correct totally, it means the price of the mortgage fluctuates, which increases when rates are low and decreases when rates are high.

As SVRMs come with mutual termination privilege, borrowers use their call option to prepay their loans when interest rates are low as they can refinance their property with a low coupon fixed rate mortgage. Banks do not use their put option even when the option is deep in the money. However, in an increasing interest rate scenario, if banks call back their SVRMs and offer new SVRMs based on the current conditions in market, the borrower will still be in the same economic situation where the coupon rates are raised due to a raise in market rates. Therefore, as only a borrower's call seems to hold any economic significance, SVRM can be modeled as a half floater with a borrower call option.

Posted Date: 9/8/2012 7:41:32 AM | Location : United States

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