Exchange-rate risk mitigation with price-level-adjusting mortgages: The case of the mexican UDI

Journal of Real Estate Research, The, Jan-Mar 2003 by Lipscomb, Joseph B, Harvey, John T, Hunt, Harold

Mexican UDIs did not exist until April of 1995. However, in order to simulate the peso return that UDI mortgages would have earned had they existed as far back as January 1983, the actual inflation data is used to create a representative UDI Index. The inflation data used in this study begins in December 1982 with the Mexican Consumer Price Index (CPI) at 1.13 and ends in January 2001 with the CPI at 338.42.8 Thus, a representative UDI Index that would have existed had Mexico initiated the UDI system in January 1983 can be created. Therefore, the representative UDI Index begins at 1.00 peso per UDI at the end of December 1982 and ends at 298.62 pesos per UDI on January 31, 2001. The representative UDI Index is plotted in Exhibit 4.

In each month of the study, an origination of a new UDI loan is simulated. The loan could be for any amount. The study assumes that there are no defaults. The loan has a real interest rate of 12% and a term of 15 years with monthly payments.9 The origination of a new UDI loan is simulated at the beginning of each month between January 1983 and February 1997, a period of 170 months. Thus, there are 170 loans, each beginning in a different month.

The loan that is originated in January 1983 matures 15-years later, in December 1997. The loan originated at the end of January 1985 and all subsequent loans do not reach maturity, but prepay the remaining balance in December 2000. The last loan is originated at the end of January 1997, which allows 48 months of amortization before paying off the balance at the end of December 2000. All unpaid balances were accelerated at the end of December 2000 because that was the end of the data set. Calculating the IRR in UDIs confirms that the rate of return in UDIs, and therefore the real rate of return in pesos, is indeed 12%. Barring default, an UDI loan will always yield the intended real rate of return to peso lenders/investors.

Nominal payments are determined by multiplying the payment amount in UDIs by the number of pesos per UDI prescribed by the current value of the UDI Index. The nominal rate of return for each loan is calculated as the IRR of the peso cash flows. The nominal rate of return changes with each loan because it is a function of the changing rate of inflation. Exhibit 5 plots the nominal IRR for each of the 170 loans above the corresponding origination date.

The highest nominal-peso rate of return over the life of a loan, 65.36%, is a loan that originated in January 1983. The lowest peso rate of return was 25.18% on a loan that was originated in February 1997. The nominal-peso return for 170 loans had a mean of 40.08% and a standard deviation of 14.56%. Between January 1983 and January 1986 the average nominal peso rate of return was 63.11%. During that same 3-year period, annual inflation in Mexico was 54.37%.

Dollar Returns

The exchange rate between the peso and the U.S. dollar was 0.02 pesos per dollar at the end of January 1983 and peaked at 10.21 pesos per dollar in September 1998.10 It declined to 9.28 in August of 2000 and rose again to 9.77 by January 2001. With respect to the dollar, the value of the peso declined 99.01% in 18 years.