Question

Joi Chatman recently received her finance degree and has decided to enter the mortgage broker business. Rather than working for someone else, she will open her own shop. Her cousin Mike has approached her about a mortgage for a house he is building. The house will be completed in three months, and he will need the mortgage at that time. Mike wants a 25-year, fixed-rate mortgage in the amount of $400,000 with monthly payments. Joi has agreed to lend Mike the money in three months at the current market rate of 6 percent. Because Joi is just starting out, she does not have $400,000 available for the loan; she approaches Ian Turnbell, the president of IT Insurance Corporation, about purchasing the mortgage from her in three months. Ian has agreed to purchase the mortgage in three months, but he is unwilling to set a price on the mort-gage. Instead, he has agreed in writing to purchase the mortgage at the market rate in three months. There are Treasury bond futures contracts available for delivery in three months. A Treasury bond contract is for $100,000 in face value of Treasury bonds.

1. What is the monthly mortgage payment on Mike’s mortgage?

2. What is the most significant risk Joi faces in this deal?

3. Treasury bond prices have a __________ relationship with interest rates. a. positive b. negative

4. As interest rates rise, Treasury bonds become _________. a. less valuable b. more valuable

5. Since Joi will _____ when interest rates rise. a. loss money b. gain money

6. In order to protect Joi from decreases in the price of Treasury bonds, she should take a _____ position in Treasury bond futures to hedge the risk. a. Long b. Short

7. Suppose that in the next three months the market rate of interest falls to 5 percent. a. How much will Ian be willing to pay for the mortgage?

Answer 1

		1.Monthly payment
	Pv	Mortgage Loan Amount	$400,000
	Rate	Monthly interest rate=(6/12)=	0.5%
	Nper	Number of Months of payment	300	(25*12)
	PMT	Monthly Payment	$2,577.21	(Using PMT function of excelwith Rate=0.5%,Nper=300,Pv=-400000)
		Excel Command: PMT(0.5%,300,-400000)
		2.Most Significant risk
		The most significant risk is Interest rate risk
		Joi will loose if interest rate goes up
	3	Treasury bond prices have a NEGATIVE relationship with interest rates
	4	As interest rates rise, Treasury bonds become less valuable
	5	Joi will loss money when interest rates rise.
	6	In order to protect Joi from decreases in the price of Treasury bonds, she
		should take a SHORT position in Treasury bond futures to hedge the risk
	7	If market Rate Fall to 5%
	Pmt	Monthly cash Flow	$2,577.21
	Nper	Number of months of cash flow	300
	Rate	Monthly interest rate=(5/12)%	0.416667%
	PV	Amount Ian will be willing to pay	$440,858	(Using PV function of excelwith Rate=0.416667%,Nper=300,Pmt=-2577.21)
		Excel command: PV(0.4166667%,300,-2577.21)