Analysis

Back-Testing

We know what mortgage rates were in the past.  And we know the past performance of equities markets.  Hence, we can “create” past Index Mortgages and track their performance against equivalent traditional mortgages.  This is called “back-testing”.

We back-tested two ensembles of 13,638 pairs of mortgages, one pair for each day in the period from 31 December 1979 to 2 May 2017.  In the first ensemble, one mortgage in each pair was a traditional mortgage and the other was an equivalent Index Mortgage.  In the second ensemble, one mortgage in each pair was an Index Mortgage and the other was an an equivalent 100% cash offset mortgage.  For a better understanding of the testing methodology, click here to download a PDF file.

In short, the Index Mortgage proved to be a better choice than the traditional mortgage on more than 97% of occasions.  To see a breakdown of the results, click here.  To see the amortisation of any any given pair of such mortgages, click here.  As against the offset mortgage, the Index Mortgage proved the better choice on on more than 73% of occasions.  However, if we assume against the double digit mortgage rates of the early 1980’s and the mid 1990’s (by running the analysis subject to an interest rate cap), that figure rises to 96%.

Testing Through Simulation

One obvious deficiency to back-testing is that there is a single known past, whereas there are many possible futures.  That issue is partially addressed by back-testing over the long term, because the long term past embodied economic cycles that are likely to repeat over the long term future.  But the problem of future uncertainty can be addressed in another way, namely through Monte Carlo simulation.  To understand what Monte Carlo simulation is click here to download a PDF file.

We tested the Index Mortgage by undertaking 5,000 Monte Carlo simulations.  For a better understanding of the simulation methodology, click here to download a PDF file.  These simulations essentially confirm the back-testing program, demonstrating that the Index Mortgage was the superior choice 92% of the time.

Special Case Comparison

Finally, we tested the Index Mortgage against a structured “borrow to invest” scenario.  Click here to download a PDF file reporting our analysis.

Conclusion

We conclude that the Index Mortgage is a robustly superior alternative to any combination of traditional credit and investment products.  This is borne out by empirical analysis (back-testing) and by stochastic simulation (Monte Carlo modelling) and is consistent with fundamental economic theory (the equity risk premium).

“The Index Mortgage is an excellent concept.  We have no hesitation in awarding it a “green light …””

Citigate Dewe Rogerson, LaunchSure Report