@techreport{NBERw9759,
 title = "Household Risk Management and Optimal Mortgage Choice",
 author = "John Y. Campbell and Joao F. Cocco",
 institution = "National Bureau of Economic Research",
 type = "Working Paper",
 series = "Working Paper Series",
 number = "9759",
 year = "2003",
 month = "June",
 URL = "http://www.nber.org/papers/w9759",
 abstract = {A typical household has a home mortgage as its most significant financial contract. The form of this contract is correspondingly important. This paper studies the choice between a fixed-rate (FRM) and an adjustable-rate (ARM) mortgage. In an environment with uncertain inflation, a nominal FRM has risky real capital value whereas an ARM has a stable real capital value. However an ARM can increase the short-term variability of required real interest payments. This is a disadvantage of the ARM for a household that faces borrowing constraints and has only a small buffer stock of financial assets. The paper uses numerical methods to solve a life-cycle model with risky labor income and borrowing constraints, under alternative assumptions about available mortgage contracts. While an ARM is generally an attractive form of mortgage, a household with a large mortgage, risky labor income, high risk aversion, a high cost of default, and a low probability of moving is less likely to prefer an ARM. The paper also considers an inflation-indexed FRM, which removes the wealth risk of the nominal FRM without incurring the income risk of the ARM, and is therefore a superior vehicle for household risk management. The welfare gain from mortgage indexation can be very large.},
}