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In the Australia, long-term, fixed-rate amortized mortgages are mostly used to finance homes as mortgage refinancing is an important phenomenon. These mortgages contain a put option that allows the borrower to repay the outstanding principal amount of the loan at any time without penalty. Money has long been used to serve as a medium of exchange for financial transactions and for real goods and services. Most transactions in the economy, however, are not visible on the surface.
This results in the relationship between the amount of money demanded and the production of new goods and services, measured by either gross domestic product or personal consumption expenditures, getting focused by the economic analyses of money demand. The output of new goods and services moves in parallel with the aggregate volumes of financial and non-financial transactions and as such the use of output rather than the volume of transactions may cost little in terms of understanding movements in the monetary aggregates. However, sometimes certain events suggest that this is not always the case. The effect of one such recent event the mortgage refinancing of residential mortgages on money demand, is being discussed below.
Mortgage refinancing and money demand
The proliferation of mortgage refinancing has resulted in a considerable increase in liquid deposits. The relation and the link between mortgage refinancing and liquid deposit growth whereby the amount of liquid deposits responds to changes in the flow of refinancing, is a stock adjustment process.
When mortgage refinancing continues to grow at a high rate, the deposit levels taper to the new desired level and as a result, the deposit growth slows down. In mid 1992 and in early 1993, the refinancing activity subsided and as a result, liquid deposit growth slowed down further and the deposits tended to run off. The Federal Reserve uses the borrowed reserves operating procedure to control the growth and the ability of the increase in mortgage refinancing to affect the level and volatility of liquid deposits. This operating procedure has, during the last decade, evolved into one that closely stabilizes the federal funds rate about a level thought to be consistent with the desired amount of discount window borrowing and the growth. Transitory increases in the demand for reserves are automatically accommodated with increases in the supply of non-borrowed reserves to maintain the desired levels of the federal funds rate and discount window borrowing. The use of mortgage securitization and servicing is responsible to some extent for the increase in deposits that follows an increase in mortgage refinancing activity.
When there is a drop in interest rates, deep-in-the-money prepayment options are used by homeowners to refinance and take new mortgages with new at-the-money prepayment options. The trend of mortgage refinancing activity brings an increase in the demand for all the money options due to the hedging activity of investors. This is reflected in the homeowners simply substituting old prepayment options for new identical prepayment options. Thus, mortgage refinancing activity becomes a mere substitution activity and as such there is no surge in the demand for at-the-money options.
It is only when the substitution market is imperfect, that there is a surge in demand for at-the-money substitutions. If this market were perfect, the supply curve of substitutions would be perfectly elastic and an increase in the demand for substitutions would not affect substitution implied volatilities. If, however, the substitution market is imperfect, the marginal cost of substitution would increase by the amount written and its supply curve would be upward sloped. A surge on the demand for options caused by an increase in mortgage refinancing could increase the implied volatility of substitutions in an imperfect market.
In the process of mortgage refinancing, a deep-in-the-money option is exchanged for on at-the-money option.
The article is from creditloan.com
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