Foreign Currency Mortgages Recast as Options on Commodity Futures

A foreign currency mortgage is debt for the purchase 
of residential property denominated in foreign currency. The borrower makes 
monthly payments in foreign currency. Devaluation of the domestic currency 
results in higher monthly payments. Practitioners have proposed solutions to 
avoid mortgage default. However, many of the practitioner solutions place excessive 
financial burdens on foreign lenders, while relieving domestic borrowers of 
responsibility. The goal of this paper is to present a solution that shares 
responsibility equitably between borrowers and lenders. First, we evaluate 
practitioner solutions by placing them in theoretical models. Then, the paper 
presents a solution, in which mortgages (loans) are viewed as derivatives (not 
loans). This is innovative, in that it takes mortgages out of banking and 
places them within investments. We recognize that investors have differential 
attitudes to risk. Accordingly, the proposed solution is presented in two 
contexts, i.e. from the perspective 
of a risk averse investor who shuns risk, or a risk taker, who is willing to 
take excessive risk to pursue returns. In the proposed solution, a call buyer 
may exercise the option, purchasing a futures contract to obtain the currency at 
a strike price that is less than the spot exchange rate. During the lengthy, 
uncertain delivery period, the exchange rate may vary more than the immediate 
period defined by the spot rate, in the form of jump diffusion models with 
stochastic volatility. The call buyer may purchase foreign currency at a strike 
price equal to the forward rates of a series of 1-period futures contracts with 
total life equal to the life of the mortgage. As strike prices continue to 
increase, with domestic currency depreciation, a repayment vehicle in the form 
of a portfolio of high-yielding securities is proposed, to produce the funds 
needed to meet forthcoming increases in monthly payments.


Introduction
Beginning in 2007-2008, residents of countries in Central and Eastern Europe acquired mortgages in the Swiss Franc at lower interest rates than the interest rates offered by their home country banks. Such foreign currency mortgages subsequently proved to be excessively risky in that the depreciation of domestic exchange rates increased monthly payments by about 10% in three months. Up to 33% of the mortgages in Croatia, 54% in Hungary, and 10% in Romania were foreign currency mortgages in 2016-2017 [1]. Such mortgages were not confined to Eastern Europe. [2] reported that 20% of the total value of mortgages made in Austria was made in Swiss francs. The interest rate benefit of borrowing in foreign currency was eliminated as the exchange rate between the Swiss franc and domestic currencies depreciated to increase monthly payments. Swiss interest rates remained lower due to the economy's greater macroeconomic stability, strengthening the exchange rate. [3] stated the following Uncovered Interest Parity Equation (1), where, E t (S t+k ) = expected future spot rate at time t + k, k = number of future periods, from time t, S t = spot exchange rate at time t, I s = interest rate in the foreign country, i.e. Switzerland, I c = domestic interest rate, i.e. Croatia, Hungary, Romania, or Austria. [4] termed uncovered interest parity as exchange rate overshooting, with an increase in the domestic price level leading to policy action to increase interest rates so that the interest rate benefit of the foreign currency mortgage is exactly offset by expectations of appreciation in the domestic exchange rate. Only part of the overshooting hypothesis may occur with foreign currency mortgages. We will show that, while initial overshooting of the exchange rate occurs, depreciation ensues, becoming the norm in successive time periods. This paper fulfills four objectives. We present a solution to defaults from rising mortgage payments by removing foreign currency mortgages from bank lending to earning investment returns. We view a foreign currency mortgage as an investment in a call option on currency futures. A borrower purchases foreign currency each month to meet the mortgage payment. If the purchase price of the currency is affordable, he or she will exercise the option, and purchase the futures contract that permits purchase of the foreign currency at the low strike price, both at present (spot price), or in the future (futures price) upon delivery of the foreign currency. The spot rate is subject to a jump-process distribution of spot exchange rates that vary due to daily changes in exchange rates in a cost-of-carry model proposed in the literature [5]. [6] observed spot rate jumps in the yen-dollar exchange rate were quickly reversed during the same day. The futures price of the foreign currency will vary from the end of the current period to the end of the delivery period in a different jump-process model from the spot Theoretical Economics Letters distribution to account for the greater fluctuation of exchange rates during a longer period. Borrowers may invest in high-yielding commodity portfolios to meet sharply increasing monthly mortgage payments. Secondly, this paper evaluates prevailing solutions that have been proposed. We show that our proposed solution is more just, as existing solutions place an excessive financial burden on lenders, while we set forth that responsibility should be shared by lenders and borrowers. Thirdly, we recognize that uncovered interest parity results from the impact of macroeconomic variables on exchange rates, so that models of solutions must include such variables. Finally, we relax the assumption of isoelastic utility of homogeneity in investor attitudes to risk. This paper creates optimal pricing models of foreign currency distributions for risk-averse borrowers, and risk-taker borrowers.
The remainder of this paper is organized as follows: Section 2 is a Review of e − = historical exchange rate, which follows a first-order autoregressive process, k 0 = spot interest rate, k t = discounted historical interest rate. Long-run PPP is violated, when the constant, k t ≥ 1, e = e − is a requirement for Short-run PPP. Co-integration tests and unit root tests have shown some support for PPP. PPP is supported when the real exchange rate is stationary, which occurs when the change in price level between two countries is equal to the change in the exchange rate, or when a unit root is not found in tests of statio-  [12] with mostly weak support for PPP, and unit root tests [13] [14], and [15] with both strong and weak evidence supporting PPP. The tests employ a variety of methodologies, including the Stock-Watson Dynamic OLS Johansen Cointegration [9], and Johansen Cointegration [10] [11], Ng and Perron Unit Root Tests [13], ADF Unit Root Tests [14], and nonlinear panel root tests [15]. In all studies, contemporary data from the mid 1990s-mid 2000s was used.
In a country with high government debt, local investors may sell their government bonds, purchasing foreign investments, thereby depreciating the domestic currency. [16] empirically proved that government debt was a determinant of the declining value of the Polish Zloty. Fiscal deficits led to increased volatility of exchange rates, as observed in a study of 85 developing and transition economies [17]. on the relationship between inflation rates, interest rates, and exchange rates. If the domestic economy has higher inflation than the foreign economy, policy makers in the domestic economy will increase interest rates with the desire to attract foreign capital. The resulting domestic interest rate will be substantially higher than the foreign interest rate, as shown in Equation (2) [26], In other words, the inflation or higher domestic price differential, ( * t t p p − ), results in a higher interest rate differential, ( where, p t = price index at time t, domestic country, According to Equation (4), the ratio of the foreign interest rate to the domestic interest rate = ratio of the final exchange rate to the current spot exchange rate. In response to the higher domestic interest rates and inflation rates, more of the domestic currency will have to be exchanged for each unit of foreign currency.
The domestic currency will be devalued with respect to the foreign currency, or, the future spot exchange rate will have a lower value than the current spot exchange rate.
where, E t (S t+k ) = expected future spot rate at time t + k, k = number of future periods, from time t, S t = spot exchange rate at time t, i t = interest rate in the foreign country, i.e. Switzerland, * t i = domestic interest rate, i.e. Croatia, Hungary, Romania, or Austria.
Empirical support for short-term uncovered interest rate parity was provided over an intraday period by [27] [4]. This sequence of outcomes is realized in the Eastern and Central European countries that borrow using foreign currency mortgages.
The next phase of the overshooting hypothesis, is that as interest rates increase, domestic investors will anticipate an appreciation of the exchange rate. [29] provided empirical support for the overshooting hypothesis for 4 open economies, whose exchange rates first depreciated, and then appreciated 1 -2 quarters after a monetary policy shock.
While the initial depreciation of exchange rates occurs in Eastern and Central European economies, currency appreciation does not occur against currencies such as the Swiss franc. As these Eastern European economies lack macroeconomic stability, failing to attract the capital inflows that permit an offsetting increase in exchange rates there is unlikely to be appreciation of their currencies. As the domestic currency continues to depreciate, more domestic currency must be exchanged to meet monthly mortgage payments, or borrowers of foreign currency mortgages continue to face higher mortgage payments. In the event that they reach a payment level that is unaffordable, widespread defaults result.

Research on the Distributions of Options on Commodity Futures
Call options on commodities permit purchases of commodities, including pork, soybeans and wheat, or natural resources, including oil. Spot prices on commodities are sensitive to short-term conditions, including, the weather, transportation, storage, or demand of commodity traders in the derivatives markets. Futures prices of commodities, during the delivery period, are relatively unchangeable, as delivery periods are short for agricultural commodities due to spoilage, and for oil due to price-setting by OPEC, respectively. Accordingly, the [30] model values commodities in terms of their spot prices, considering the futures prices to be equivalent to a riskless bond with constant risk-free interest. Likewise, [31] assumed that futures prices would be equivalent to a zero-coupon bond, with minimal risk. [32] added variability to spot prices, with jumps in current commodity prices, to model changes in daily commodity prices due to weather or storage, and unchanged futures prices. We challenge the assumption of constant interest rates for futures prices, given that uncertainties in macroeconomic variables will alter interest rates during the delivery period in support of certain commodity models, that recognize price fluctuations in both spot and futures prices, as representing volatility that may vary over time, and must be included in valuation. Such volatility may be time-varying [33] [34], or static [35]. This paper concurs with the inclusion of volatility with large currency fluctuations represented by jump process models. This paper sets forth that a jump diffusion model is more appropriate, both to describe current spot price distributions, and futures price distributions during the long delivery period, given that currency prices depend upon macroeconomic variables, which experience both short-term and long-term fluctuations [33]. However, the [33] model does not make provision for macroeconomic variables.

Existing Solutions to Stabilizing Mortgage Payments in Foreign Currency Mortgages
Limiting Increases in Foreign Currency Payouts. We show that the foreign lender will experience significant losses from the following strategy of the borrower limiting increases in foreign currency payments. The mortgage repayment schedule may be described as, where, D f = Foreign Currency Debt, DP f = Down Payment in Foreign Currency, Rearranging Equation (4), If ex is the exchange rate and DC is the domestic currency, as the domestic currency gets devalued over time, larger amounts of domestic currency will have to be exchanged for the foreign currency, or As the last payment on the mortgage may be 15 years into the future, and since mortgage payments are increasing monthly, the final payment may be exponentially higher than the initial payment.
Therefore, Equation (6) may be rewritten as, Normally, depreciation of the domestic exchange rate, will result in an increase in monthly mortgage payments in foreign currency. However, the central bank will not permit this increase to occur, leading to possible default as borrowers underpay. DC*ex at the higher foreign currency conversion rate expressed in Equation (8) will fail to occur, leading to losses to the lender.
The source of the devaluation of the domestic currency is the differential inflation rate, leading to differential real interest rates, leading to differential nominal interest rates, and finally, devaluation of the exchange rate. The impact of differential real interest rates, x, and differential inflation rates y, on differential nominal interest rates about a point, (a, b), is expressed as a Taylor series expansion, The change in exchange rate is the first derivative of Equation (9), as follows, At the upper bound, the second derivative of the left side of Equation (9), must have the maximum mortgage payment, DC n ex n . Yet, this mortgage payment is constrained to remain at DC 1 , resulting in significant losses to the foreign lender, Cap the domestic interest rate. Certain central banks cap the domestic nominal interest rate. Borrowers will rush to convert domestic currency at the low exchange rate. The supply of foreign currency will be quickly exhausted, so that lenders will receive smaller monthly mortgage payments, after the first few months. Foreign lenders will lose, as their monthly mortgage income decreases, while borrowers will gain, as their payments decrease. We derive an equilibrium between the supply and demand for foreign currency, which is violated by capping the domestic interest rate. The equilibrium in Equation (14) of parity between the value of the domestic currency and the value of the foreign currency is violated.
At the equilibrium exchange rate, The supply of foreign currency = supply of domestic currency to purchase foreign currency, Given the following notation, x tf = trade balance, foreign country, x gf = government deficit, foreign country, x if = inflation, foreign country, x td = trade balance, domestic country, x gd = government deficit, domestic country, x id = inflation, domestic country.
To examine if Equation (12) is upheld, we represent each of the variables in Equation (12) as a Legendre function [34]. The left side is, Subtracting the right side from the left side yields,  Differentiating with respect to trade t, government debt, g, and inflation, i, and dividing throughout by cv d , Convert to a Domestic Currency Mortgage. Central banks may forego the need for borrowers to purchase foreign currency altogether, by converting the foreign currency mortgage to a domestic mortgage. The foreign lender will lose the mortgage payments entirely.
The domestic bank pays the foreign lender for the foreign currency loan. The payment, B, includes the present value of all future mortgage payments that the foreign lender will no longer receive. We model these foregone payments as a Laplace distribution in Equation (14). A Laplace distribution is an S-shaped double-exponential distribution that could approximate exponentially rising future exchange rates [35]. To account for additional discontinuities due to exchange rate jumps, we add the first moment of the Laplace distribution in Equation (15), Equation (16) is equivalent to the new domestic currency mortgage in Equation (17), whose monthly payment = (DC(1 + r)), where r, the prevailing interest rate, is an increasing function of the market interest rate for an adjustable-rate mortgage.
Equating the right side of Equation (15) and Equation (16) yields the stream of payments for the domestic mortgage, which, with the spread, is higher than the foreign currency mortgage.
r ' = marginal product of capital, X = exports, IM = imports, The LM relationship is, Or, Money supply/Price level = Liquidity Preference as a function of the real interest rate, r, and income, An increase in national income, Y, due to an increase in investment, decrease in the real interest rate, r, and increase in exports, X, may be achieved by differentiating Equation (19), assuming that government spending, G, is a constant, with respect to I(r), and X, As an increase in national income increases business cash flow, the right side of Equation (22) may be substituted in the LM relationship in Equation (21), Strong trade balances, (1-IM), low relative inflation, P, and low real interest rates, r, placed upward pressure on the Swiss franc, S t .
The change in the expected future value of the Swiss franc suggests that (1 + i s ), the value of the Swiss franc, must increase over (1 + i c ), the value of the Euro, so that the right side of Equation (23) Despite numerous attempts by the Swiss National Bank to strengthen the Euro, with more purchases of Euros with Swiss francs, the underlying macroeconomic strengths of the Swiss economy prevailed. In January 2015, the peg was lifted, the EUR/CHF appreciating to the true value to 1.5545 EUR/1 CHF. In Figure 1, the peg shifts from point O to point P.
The first derivative of Equation (27) with negative values for change in output, x 1 , change in investment, x 2 , and change in trade, x 3 , results in an exchange rate depreciation, (1-i s ) > nominal interest rate differential, (r − r'), shows the depreciation in the exchange rate from reduction in output, reduction in investment, and a negative trade balance.
( )   The mortgage is refinanced as the balloon payment becomes the new debt.
The new mortgage becomes a foreign currency mortgage, with continuously rising monthly payments. The financing of the balloon payment is as follows,

The Proposed Solution for Emerging Market Borrowers
This paper proposes that Eastern European borrowers reposition their mortgages as options on commodity futures. At time 0, they must convert domestic currency into a foreign currency down payment, paid to the seller of residential property. From the first month onwards, for about 15 years, they pay a monthly mortgage payment to a foreign bank, exercising a call option to purchase a foreign currency futures contract. Initially, the foreign currency price is low, so the borrower exercises the option, obtains the futures contract, and purchases the foreign currency at an affordable price. Upon repeated devaluation, monthly payments continue to increase, so that the call buyer will be required to purchase options at progressively higher strike prices. This disincentivizes exercise of the call option. To encourage option exercise, a source of funds is created, that meets the cost of increasing strike prices. Each mortgage payment may be split into 2 parts. One portion may be allocated to current principal and interest payments, whereby conversion from domestic currency to foreign currency, occurs at the spot exchange rate. The remaining payment is allocated to the purchase of a series of 1-year futures contracts, paid from a high-return portfolio of oil, gold and silver, which have higher returns than the high-return equities portfolio of Section 3. The returns on this high-return portfolio pay the incremental increase in mortgage payments, thereby shielding borrowers from default.
Risk-Averse Purchasers of Foreign Currency. Borrowing using an increasing foreign currency mortgage is an aberration for the risk-averse borrower, who usually avoids default by selecting a fixed domestic currency mortgage. [38] modeled aberrant behavior as the third derivative of a Taylor The upper bound, or maximum spot and futures call price, occurs at ή 1 → , A risk-averse call buyer purchases the option on Eastern European currency futures. The option is highly volatile, its premium varying intraday, by the hour.
We assume that options are priced on futures contracts that arrive by the nanosecond in [39]'s formulation, (α w − k w ) = mean option prices, σ w = standard deviation of option prices, dq = random variable Poisson process. Alternatively, this pricing distribution may be represented as a martingale process. The martingale process assumes that the conditional expectation of the next value is independent of historical values [40]. As option prices are completely unpredictable from past prices [41], we may approximate the option price distribution to de Moivre's martingale, with the probability, p, of exchange rate depreciation, and q = 1 -p, of unchanged exchange rates. Let X n+1 = X n +/− 1, where + = depreciated exchange rates, and − = unchanged The right side of Equation (41) is equal to, As p, the probability of exchange rate depreciation, continues to increase in each period, the borrower must invest in a high return portfolio of oil, gold, and platinum 1-year maturity commodity futures contracts. Returns on these investments will be sufficiently high to meet the mortgage payment even with rising monthly payments.
The shape of the oil price distribution in Figure 3, derived from actual oil price charts from 2010-2015 [41], conforms to a gamma distribution. The cumulative density function of a gamma distribution is defined by a shape parameter, k, and a scale parameter, θ. For values of k = 0.5 -7.5, and θ = 0.5 -2.0, Theoretical Economics Letters Decreases in commodity returns act as a signal to the foreign currency borrower to sell the commodity future, use part of the proceeds to pay the mortgage payment, and then, purchase a futures contract on another commodity, like copper, with increasing future value. Figure 3 shows that gold or platinum have different price distributions from oil. The continuous wave distribution may be likened to a Bessel function, [43], We employ Bessel functions, to which we add dichotomous Bernoulli functions to account for price increases and price decreases, to describe gold or platinum price distributions in Equation (48) [44], The sell signal for gold and platinum is followed by purchase of a futures contract, whose projected forward prices show increases, such as copper.

Risk-Taker Purchasers of Foreign Currency
Risk-takers gain satisfaction from taking risk. [45] describes such utility as risk-causing. [46] described such individuals as deriving utility from the perception that the gambling behavior could yield significant enough rewards to uplift them to higher socioeconomic status. He theorized that risk-takers have high initial risk, and high optimal levels of risk, indicating that they are risk-takers from the outset, with acceptance of high levels of subsequent risk. [47] concurred with his empirical finding that such individuals would take unfair bets. Given that the foreign currency mortgage is a highly risky liability, risk-takers accept it initially, regardless of consideration of risk. They continue to purchase foreign currency, long after depreciation of the domestic currency, as they are not adversely affected by increased risk from continuously appreciating foreign currency values. Their utility function may be modeled by Wronskian relations with rapid acceptance of higher foreign currency values in the G L segment of the utility function depicted in Figure 4. Prices at intersection of the Wronskian function with the jump process yield optimal conversion prices. The Wronskian utility function may be modeled as [34].
Equating the second derivative of the Wronskian utility function with the jump process weighted by price yields the formulation of the price of foreign currency, P * , for the risk-taking borrower,

An Alternative Solution to Preserve Foreign Currency Values with Default of Principal
Another solution would be to short the domestic currency as it depreciates. The proceeds may be sufficient to offset the loss from default of the foreign currency mortgage, until the loan is sold to a domestic lender.
Risk-Averse Investor. The proceeds from the short sale may be presented as The necessary condition for optimization is the first derivative of Equation (53)

Conclusions
This paper has theoretically explored the problem of defaults of foreign currency mortgages. Existing solutions have largely been found to offer temporary relief to buyers confronting increasing monthly payments. By recasting the repayment process as a commodity purchase, and by offering an investment portfolio that caters to both to borrowers who are modestly impacted by foreign currency devaluations, and those who are significantly affected by foreign currency devaluations, this paper has sought to offer a solution that benefits both lender and borrower. This paper perceives borrowers as varying in risk aversion, yielding two sets of solutions as each utility function intersects with the price distribution.
The theoretical basis for the interest rate differential between the two economies, lies in uncovered interest parity.
The primary implication of this paper for banking is that the proposed solution is suboptimal, in that it does not ameliorate the underlying macroeconomic weaknesses that lead to the interest rate differentials that cause domestic currency depreciation, and in turn, increase monthly mortgage payments. Central banks should curb frequent depreciation by aiming for low, stable real interest rates of about 2% -4%, followed by controlling inflation, reducing the budget deficit, and reducing the trade deficit to achieve long-term macroeconomic, and exchange rate stability.
The alternative solution of shorting the domestic currency to offset defaults of foreign currency mortgages raises research questions that must be explored in future work. The short selling strategy would be more effective, provided that management is willing to accept the borrowing costs. Why has this strategy not been used extensively? It is possible that the dichotomy between the foreign currency market in which currencies are traded and banks which supply mortgages is absolute for risk-averse traders, so that traders in the foreign currency market rarely interact with bankers who originate mortgages. It would not occur to certain bankers that a problem in banking could be solved through trading in the financial markets.