Foreign currency mortgages – risks, returns, and policies for a retail carry trade

The carry trade, i.e. the borrowing/selling of low interest rate currencies and simultaneous investing in/buying of high interest rate currencies, has been a constant topic in financial market commentaries over the last couple of years. The topic is especially interesting from an international finance perspective, where it can be used to show if/how covered and uncovered interest rate parity regimes work or don’t work.

On the retail level a carry trade is harder to find and execute since transaction costs would be prohibitive, especially in the short run. However, during the years before the financial crisis a newly developed retail instrument used at least one side of the carry trade: Foreign Currency Mortgages. These have been very popular for quite some time in countries like Germany, Austria, and later in various Eastern European countries, especially Hungary. In the U.S. a subsidiary of the British bank Lloyds TSB started to offer foreign-denominated mortgages for residential property in 2007, and currencies used include for example the Japanese Yen or the Swiss Franc.

In the first part of the paper we use a hypothetical example which illustrates the benefits and risks of a residential foreign exchange mortgage. Based on a fictitional US home owner taking out a CHF mortgage we then use data material from a foreign currency website like www.oanda.com and show how the periodic payments and the loan balance would have developed over time, based on past exchange rate fluctuations, exchange rate forecasting scenarios, and ex-post real exchange rate developments. A Monte Carlo Simulation based on @RISK is used to “visualize” the foreign currency risk and to show what the potential profits and losses from such a strategy could be for the borrower.

The second part of the paper transfers the same approach to a hypothetical Hungarian home owner who took out a CHF mortgage at the same time like the US home owner. It shows risks and return characteristics from a Hungarian viewpoint and includes real developments like actions taken by the Hungarian Central Bank to alleviate the problems stemming from excessive use of FX mortgages. We conclude with FX mortgage policy recommendations which could be helpful for Bank Regulators and Central Banks as guidelines for the future.