Farm mortgage decisions under varying market interest rates
Abstract
The purpose of this study is to determine the likely impact of market interest rates on the choice of farm mortgages for the borrower. The study focuses on choice of mortgages with different rate repricing periods. The stochastic process of market interest rate movement is first estimated using a state space time series model. A simulation model is then built up to determine the preferred refinancing strategy and the initial mortgage choice. Using the simulation model, we addressed: (1) the preferred refinancing policy and the impact on the mortgage decisions of the varying market interest rates, (2) the impact of leverage choices on the mortgage decisions, (3) the effect of the decision maker's temporal risk preference, and (4) the effect of initial market interest rates on refinancing activities. Based on the experimental results, it was found that the preferred expected cost calculation period does not exceed 3 years and the risk adjustment parameter lies within the range of zero to 1%. Results of the study also indicate that a higher (lower) yield curve makes shorter (longer) term loans more attractive while a flatter (steeper) yield curve makes longer (shorter) term loans more attractive. A simple decision rule of thumb was developed depending on only two parameters. Applying the rule to the historical data of past 30 years, we found the results well explained the market transition. The leverage effect was found to indicate that demand for short term loans is higher both with very low and very high leverage. The experimental results show that the more temporal risk averse a decision maker is the more likely the long term loan is better. The market interest rates are also found to affect the refinancing activities. A higher (lower) yield curve results in more (fewer) loans being refinanced. The short term loan as a refinancing tool becomes more attractive the higher the yield curve. The way the slope of the yield curve affects the loan choice is as expected. The steeper the yield curve the better the short term loan as a refinancing tool.
Degree
Ph.D.
Advisors
Baker, Purdue University.
Subject Area
Agricultural economics|Finance
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