Tutorial 5

Solutions to Questions

Question 1
How do inflationary expectations influence interest rates on mortgage loans?
Answer:
Higher inflationary expectations lead to higher interest rate on mortgage.
Most savings institutions had been making fixed rate constant payment mortgage loans with
relatively long maturities, and the yields on those mortgages did not keep pace with the cost of
deposits. These problems prompted lenders to change the mortgage instruments to now make more
mortgages with adjustable interest rate features that will allow adjustments in both interest rates and
payments so that the yields on mortgage assets will change in relation to the cost of deposits.

Question 2
What is the difference between interest rate risk and default risk? How do combinations of terms in
ARMs affect the allocation of risk between borrowers and lenders?
Answer:
Interest rate risk is the risk that the interest rate will fluctuate during the life of the loan. The
interest rate charged on a particular loan may be insufficient if economic conditions change
drastically after a loan is made. The uncertainty about what interest rate to charge when a loan is
made can be referred to as interest rate risk
Default risk is the risk that borrowers will default on obligations to repay interest and principal,
according to the terms of the loan agreement.
The fact that ARMs shift all or part of the interest rate risk to the borrower, the default risk will
generally increase to the lender, thereby reducing some of the benefits gained from shifting interest
rate risk to borrowers.

Question 3
If an ARM is priced with an initial interest rate of 8% and a margin of 2% (when the ARM index is
also 8% at origination) and a fixed rate mortgage (FRM) with constant payment is available at 11%,
what does this imply about inflation and the forward rates in the yield curve at the time of
origination? What is implied if a FRM were available at 10%? 12%?
Answer:
As a FRM’s interest rate increases from 10% to 11%, and then to 12%, greater inflation and/or
greater uncertainty with respect to inflation is implied.
The initial interest rate and expected yield for all ARMs should be lower than that of a FRM on the
day of origination, holding all other variables the same. The extent which the initial rate and
expected yield on an ARM will be lower than that on a FRM or another ARM depends on the terms
relative to payments, caps, etc. One would expect the difference between interest rates at the point
of origination to reflect expectations of inflation and forward rates.

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 Question 4
A price level adjusted mortgage (PLAM) is made with the following terms:
Amount = $95,000
Initial interest rate = 4%
Term = 30 years
Points = 6%
Payments to be reset at the beginning of each year.
Assuming inflation is expected to increase at the rate of 6% per year for the next five years:
a. Compute the payments at the beginning of each year (BOY).
b. What is the loan balance at the end of the fifth year?
c. What is the yield to the lender on such a mortgage?
Answer:
(a) Compute the payments at the beginning of each year of the PLAM.
PV =$95,000
N = 360
I/Y = 4/12
FV=0
 Solve for PMT = $453.54
The payment for year 1 is $453.54.
The rest follows from this.

(1) (2) (3) (4) (5) (6) (7) (8) (9)

Monthly
Annual Interest Monthly Monthly EOY Inflation
BOY Interest Rate Interest Amort Annual Balance Adjusted
Year Balance Rate (2)/12 Payments (3) x (1) (4) - (5) Amort (1) -(7) EOY
Balance

1 $95,000 4.00% 0.33% $453.54 $316.67 $136.88 $1,672.98 $93,327 $98,927

2 98,927 4.00% 0.33% 480.76 329.76 151.00 1,845.61 97,081 102,906
3 102,906 4.00% 0.33% 509.60 343.02 166.58 2,036.05 100,870 106,922
4 106,922 4.00% 0.33% 540.18 356.41 183.77 2,246.15 104,676 110,956
5 110,956 4.00% 0.33% 572.59 369.85 202.73 2,477.92 108,479 114,987

(b) The loan balance at the end of the fifth year = $$108,479.

(c) IRR(CF1, CF2, ….CFn)

CFj nj
-$89,300
453.54 n = 12
480.76 n = 12
509.60 n = 12
540.18 n = 12
572.59 n = 11
572.59 + 114,987 n=1

Solve for the annual IRR: = 0.93% x 12 = 11.21%

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Refer to the solution in Excel file for more details.

Question 5
A floating rate mortgage loan is made for $100,000 for a 30-year period at an initial rate of 12%
interest. However, the borrower and lender have negotiated a monthly payment of $800.
a. What will be the loan balance at the end of year 5? What will be the loan balance at the end of
year 30?
b. How much interest will be accrued as negative amortization in year 1 if the payment remains at
$800? How much interest will be accrued as negative amortization in year 5 if the payment remains
at $800?
Answer:
(a) Loan Balance at the end of year five is $116,333.93
Solution:
n = 5x12 or 60
i = 12/12 or 1
PV = -$100,000
PMT = $800
Solve for the loan balance:
FV = $116,333.93

Loan Balance at the end of year 30 is $798,992.83

Solution:
n = 30x12 or 360
i = 12/12 or 1
PV = -$100,000
PMT = $800
Solve for the loan balance:
FV = $798,992.83

(b) During Year 1: Interest paid will be $800 per month, and interest accrued as negative
amortization will be $200 per month compounded monthly at 12% over 12 months a year (12%/12),
for one year we have -$2,536.50.
Solution:
n = 12
i = 12/12 or 1
PV = 0
PMT = $200
Solve for the future value:
FV = -$2,536.50
Therefore, interest paid equals $9,600 (or $800x12=$9,600) in year one and interest accrued is
$2,536.50.

During Year 5: calculate the balance at the beginning of year 5:

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 n = 4x12 or 48
i = 12/12 or 1
PV = -$100,000
PMT = $800
Solve for the loan balance:
FV = $112,244.52

Interest due during first month of year 5:

$112,244.52 x (12%/12) = $1,122.45
As payment is still $800, so the amortization each month is $800 - $1122.45 = - $322.45
Negative Amortization during year 5:
n = 12
i = 12/12 or 1
PV = 0
PMT = $322.45
Solve for negative amortization:
FV = -$4,089.41
Therefore, total interest paid during year five is $9,600 (or $800x12=$9,600) in year five and
interest accrued is $4,089.41.

Refer to the solution in Excel file for more details.