## What is the monthly mortgage payment on Mike’s mortgage

Chatman

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 $500,000

with monthly payments.

Joi has agreed to lend Mike the money in three months at the current market rate of 8

percent. Because Joi is just starting out, she does not have $500,000 available for the

loan; so 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 mortgage. 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 (Hint: Use time value

of money you have learned to solve this problem ?

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

3. How can Joi hedge this risk? Should Joe use a long hedge or short hedge?

4. Suppose that in the next three months the market rate of interest rises to 9 percent.

a. How much will Ian be willing to pay for the mortgage?

b. What will happen to the value of Treasury bond futures contracts? Will the

futures position Joe takes increase or decrease in value?

5. Suppose that in the next three months the market rate of interest falls to 7 percent.

a. How much will Ian be willing to pay for the mortgage?

b. What will happen to the value of T-bond futures contracts? Will the futures

position Joe takes increase or decrease in value?

6. What is the major risk Joi faces in using Treasury bond futures contracts to hedge

her interest rate risk?

Solution preview

The Monthly Mortage Pay is given by the Mortgage amount divided by the Discount Factor

That is:

Monthly Mortage Pay = Mortgage amount / Discount Factor

The Discount factor = [{(1 + i) ^n} – 1] / [i (1 + i) ^n]

Where i=8/12 and n 25*12, thus i=0.0067% and n=300

Thus the discount factor = [{(1 + 0.0067%) ^300} – 1] / [0.0067% (1 + 0.0067%) ^300]

Discount factor = $129.56452

Therefore, the monthly payment amount………………………

APA

395 words