The Interaction between Interest Rate Risk and Credit Risk of Adjustable Rate Mortgage

The article uses a bivariate pricing lattice to observe different interest rates and housing prices. Then we use loan-to-value ratio and payment-to-income ratio to set the default conditions. And the probabilities of default are then calculated. We have sensitivity tests that describe the changes of the probabilities of default due to the changes of different variables including initial interest rate, mean-reverting speed, volatility of interest rate, cash service flow, volatility of house price and correlation coefficient between interest rate and housing price.he conclusions are as follows:1)Under the same condition except that interest rate settings are different, the probabilities of default of adjustable rate mortgages are higher than which of fixed rate mortgages.2)Initial interest rate, volatility of interest rate, cash service flow and volatility of housing prices appear to be positively related to the probabilities of default.3)Mean reverting speed of interest rate and correlation coefficient between interest rate and housing price appear to be negatively related to the probabilities of default.