Fixed rate mortgages reduce households’ exposure to interest rate risk. With a long-term, low-down-payment fixed rate mortgage, the duration of a house times its value will approximately equal the duration of the mortgage on the house times its value. Changes in the value of the house due to changes in market interest rates will be offset by changes in the value of the mortgage. On the other hand, the financial intermediary issuing the mortgage will be exposed to interest rate risk.
In an effort to reduce exposure to such risk, intermediaries have introduced variable rate mortgages. These instruments allow intermediaries to match the duration of the mortgages they issue against the duration of their deposits. In effect, variable rate mortgages eliminate intermediaries’ interest rate risk by transferring the risk to households. Because households are not as efficient in managing risk as intermediaries, this transfer increases the price of risk-bearing in the economy as a whole.