Foreign Currency Mortgages Recast as Options on Commodity Futures
Theoretical Economics Letters
A foreign currency mortgage is debt for the purchase of residential property denominated in foreign currency. The borrower makes monthly payments in foreign currency. Devaluation of the domestic currency results in higher monthly payments. Practitioners have proposed solutions to avoid mortgage default. However, many of the practitioner solutions place excessive financial burdens on foreign lenders, while relieving domestic borrowers of responsibility. The goal of this paper is to present a
... is to present a solution that shares responsibility equitably between borrowers and lenders. First, we evaluate practitioner solutions by placing them in theoretical models. Then, the paper presents a solution, in which mortgages (loans) are viewed as derivatives (not loans). This is innovative, in that it takes mortgages out of banking and places them within investments. We recognize that investors have differential attitudes to risk. Accordingly, the proposed solution is presented in two contexts, i.e. from the perspective of a risk averse investor who shuns risk, or a risk taker, who is willing to take excessive risk to pursue returns. In the proposed solution, a call buyer may exercise the option, purchasing a futures contract to obtain the currency at a strike price that is less than the spot exchange rate. During the lengthy, uncertain delivery period, the exchange rate may vary more than the immediate period defined by the spot rate, in the form of jump diffusion models with stochastic volatility. The call buyer may purchase foreign currency at a strike price equal to the forward rates of a series of 1-period futures contracts with total life equal to the life of the mortgage. As strike prices continue to increase, with domestic currency depreciation, a repayment vehicle in the form of a portfolio of high-yielding securities is proposed, to produce the funds needed to meet forthcoming increases in monthly payments.