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1)If a homeowner defaults on their mortgage loan, under what circumstances would the mortgage lender agree to a short sale? 2)You are currently maintaining a conventional 30-year mortgage loan with your bank and the annual interest rate is 8%
1)If a homeowner defaults on their mortgage loan, under what circumstances would the mortgage lender agree to a short sale?
2)You are currently maintaining a conventional 30-year mortgage loan with your bank and the annual interest rate is 8%. Your bank manager now offers you a 30-year adjustable rate mortgage (ARM) at 2% but the rate will be adjusted once each year. Evaluate your current mortgage and the new option in terms of the following: Risk that the monthly payment will change over the next 30 years, and, interest rate risk. Explain your understanding on the risk involved in this question and its impact on both financial institutions and customers.
3)Explain how each of the given factors may affect bond demand and supply during a period of robust economic growth: Wealth, Default risk, and General business conditions.
4)A bond has a PAR value of $1,000 with a 12% coupon and a 4% semi-annually compounded yield. What is
the bond’s duration given that there are two years left to maturity?
Expert Solution
1)
Short sale is something when lender agrees to take a less amount as mortgage payoff as to facilitate the sale. In this case lender forgives the remaining balance of loan.
Cases under which short sale occurs
- The owner is financially distressed.
- value of house decline and mortgage loan value is more than that of home value.
Conditions for short sale
- mortgage lender permission is required before proceeding for such thing.
Example
If a lender lends 500000rs to X in mortgage of his house worth 500000rs. But market price of property falls down to 480000rs so in this case its a 20000rs loss in transaction if lender ready for short sale.
Benefits and limitation
Short sale does not provide much benefit to both the parties, the only benefit is that lender gets cheap rate property at a loss of 20000rs.
2)
| Parameter | Current Mortgage | New Option |
| Risk that the monthly payment will change over the next 30 years | No such risk, the interest rate is fixed and hence the monthly payment is fixed | It bears the risk of change in monthly payment on every reset date and that will be once every year. |
| Interest rate risk | The interest rate is fixed over the term and hence there is an interest rate risk. The present value of your mortgage will keep changing based on the changes in the interest rate | There will be no interest rate risk here as it is an adjustable rate mortgage |
| Impact on financial institution | The interest income of the financial institution remains fixed. It's known and certain There is no variability in the income. This can lead to a better planning. | The interest income is a variable. And it will change on every reset date. So the institution is subjected to variability in its interest income. |
| Impact on customers | The interest expense of the customer remains fixed. It's known and certain There is no variability in the expense. This can lead to a better planning. | The interest expense is a variable. And it will change on every reset date. So the customer is subjected to variability in its interest expense. |
3)
A. Wealth- wealth is one of the factor which will be impacting the demand and supply the bonds during this phase of rapid economic growth because when there would be a higher amount of wealth in the hands of the people, there will be a rather attracted to invest into equity because at the time of the robust economic growth, equities are offering the high rate of return but they are also trying to allocate their assets to the bonds and they will be trying to invest in bonds in order to diversify their overall portfolio and this diversification will be increasing because various companies will also be offering a higher rate of bond yield at the time of economic growth because they can facilitate a high interest because of higher earning so there will be a higher allocation towards bonds in compared to normal economic recession in early periods.
B. Default risk- at the time of high economic growth, there are very low default risk associated with interest payments because there is a high liquidity present in the system and businesses are making high profits so there is a very low risk related to the default risk at the time of robust economic growth
C. General business condition during economic growth scenarios are forecasted at having a favourable market conditions in order to maximize their profits so businesses will be exposed to lesser risks and their bonds will be more safe at the time of the economic growth as they are less bound to default and general economic conditions will be supportive as the economy will be on a growth trajectory.
4)
Answer : Below is the Table showing Calculation of Duration :
| Year (Weights) | Cah Flows | PVF @2% | Discounted Cash Flows | Weights * Discounted Cash Flows |
| 1 | 60 | 0.980392157 | 58.82352941 | 58.82352941 |
| 2 | 60 | 0.961168781 | 57.67012687 | 115.3402537 |
| 3 | 60 | 0.942322335 | 56.53934007 | 169.6180202 |
| 4 | 1060 | 0.923845426 | 979.2761516 | 3917.104606 |
| Total | 1152.309148 | 4260.88641 |
Duration = Sum of ( Weights * Discounted Cash Flows) / Discounted Cash Flows
= 4260.88641 / 1152.309148
= 3.70 half years or 1.85 years (3.70 / 2)
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