Default Risk in Adjustable Rate Mortgages: Effects of Changes to CPF Withdrawal Limits in Singapore Brent W. Ambrose @ , Yongqiang Chu *1 , Jay Sa-Aadu # and Tien Foo Sing *2 Revised: July 6, 2004 Abstract: Adjustable rate mortgages (ARMs), which allows mortgagees to adjust the contracted interest rate to market interest rate at agreed intervals, are the prevailing type of mortgage in Singapore and many Asian countries. Analyzing the default risks in ARMs is difficult because of the path-dependence of the mortgage interest rates. The pricing process for the defaultable ARMs is even more complicated when applied to Singapore housing market, where the use of the Central Provident Fund (CPF) savings and monthly contributions to supplement the housing purchase are indispensable in the home financing system. The paper models the mortgage default options in ARMs taking into consideration the special settings of CPF system, and evaluates the impact of how changes to CPF withdrawal rules will have impact on the mortgage default risks. Numerical analyses were conducted using the least square Monte Carlo simulation, and the results showed an inverse relationship between the withdrawal cap and default risk premiums in ARMs. When the withdrawal cap is tightened from 150% to 120% of the original house price, default risk premiums increase from 0.42% to 0.86 for the mortgagor; and from 1.10% to 1.51% for the mortgagee. We also observed that the CPF saving interest rates, the house price volatility and interest rate volatility are positively related to the default option premiums in ARMs. Key Words: Adjustable rate mortgage, Mortgage default option, CPF withdrawal limit JEL Classification: G12, G21, G23 @ Gatton College of Business and Economics, University of Kentucky, Lexington, KY 40506, USA, ambrose@uky.edu . *1 Department of Real Estate, National University of Singapore, 4 Architecture Drive, Singapore 117566. g0202465@nus.edu.sg # Fiance Department, Henry B. Tippie College of Business, The University of Iowa S252 Pappajohn Building, Iowa City, IA 52242, USA. Jsa-aadu@uiowa.edu . *2 Corresponding author. Department of Real Estate, National University of Singapore, 4 Architecture Drive, Singapore 117566. rststf@nus.edu.sg . This Paper was presented at the 2003 AREUEA International Conference Krakow, Poland. The Authors wish to thank Professor Richard Buttimer and the participants in the conference for their valuable comments.