Managing the Short‐Term Interest Rate Exposure Inherent in Adjustable Rate Mortgage Loans

This paper develops a model for determining the level of, and changes over time in, the short‐term interest rate exposure contained in adjustable rate mortgage loans (ARMs). Results of the study indicate that movements in the underlying adjustment index can create both upward‐movement or downward‐movement interest rate risk for lenders whose ARMs carry rate adjustment limits. The model presented here is useful for designing hedging strategies for ARM loans, and for analyzing the impact of new originations on the interest rate exposure of the ARM portfolio.