CMOs, Duration Risk and a New Mortgage

Abstract

This article presents an alternative mortgage that retains the fixed-rate feature of a fixed-rate mortgage (FRM), but accelerates the principal amortization when interest rates rise, exposing the buyer to less duration risk in a rising interest rate environment. This mortgage, labeled the adjustable amortization mortgage (AAM), is shown to have lessened interest rate risk for the buyer as well as lower default risk, suggesting that it should be priced higher (at a lower rate of interest) than the typical FRM. It is also shown that mortgage-backed securities collateralized by an AAM have much less price volatility than mortgage-backed securities backed by FRMs.