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

Conclusion

Enabling markets to function more efficiently, thus, providing the capital needed to better house the country's population, is an important goal of the Mexican government. The risks associated with investing in Mexican mortgages have been excessive, as evidenced by the country's historically high mortgage interest rates. Today, the few Mexicans who can access the formal mortgage market still pay an exceptionally high real rate of interest. This extreme cost of mortgage financing continues to reduce the quantity and quality of housing that Mexicans can afford. Thus, the solution is to reduce lenders' risk and uncertainty, which should in turn reduce mortgage interest rates, attract more capital and improve housing affordability.

Mexico could benefit greatly from an influx of foreign capital seeking to take advantage of the country's high real mortgage rates. However, international investors tend to fear exchange rate risks associated with peso investments. Between January 1983 and January 2001, the peso lost 99.01% of its value with respect to the U.S. dollar. This history of a near total loss in peso value raises concerns that the value of dollar investments in peso-denominated securities will be eroded, possibly to negative rates of return. This study demonstrates that the UDI mortgage has the potential to mitigate that risk, thus allaying some of the apprehension harbored by international investors considering investing in Mexican mortgages. The salient question is, does Mexico's price-level-adjusting UDI mortgage provide adequate exchange-rate risk mitigation or is the risk of exchange-rate loss too great for dollar investors?

To answer that question, the origination of UDI mortgages was simulated each month between January 1983 and January 1997 and they were treated as though the lender/investor was purchasing them with dollars. No external exchange-rate protection was provided. Only the implicit protection of inflation adjustments was in effect. The results indicated that the real-dollar rate of return was slightly greater on average than the peso return (14.39% compared to 12% per year). The difference was a net profit in the currency translations in and out of the peso. Although the dollar return may be high (depending on total risk), the standard deviation is also high, 3.45% per year, given that the real peso return exhibited a standard deviation of zero.

An examination of individual mortgages revealed the following: the real-dollar return ranged from a maximum of 23.75% to a low of 8.45%, even though the real-peso return was fixed at 12%. Noting that all of the deviation above and below 12% was attributable to exchange rate fluctuations, the study examined the consequences of investing only when the peso was weak with respect to the dollar. Mortgages were not purchased in any month in which the peso was strong.

To gauge the strength of the peso, its value was estimated based on purchasing power parity theory. Cointegration regression methodology was employed to estimate the theoretical exchange rate as indicated by PPP. A simple rule was established that said to invest dollars in UDIs only when the peso was undervalued with respect to PPP. Following that simple rule, the average real-dollar return increased from 14.57% to 16.85%. At the same time, the standard deviation of returns fell from 3.66% to 2.48%.