UCLA ECON 103 - Chap005 (1) (12 pages)

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Chap005 (1)



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Chap005 (1)

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Pages:
12
School:
University of California, Los Angeles
Course:
Econ 103 - Introduction to Econometrics
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Chapter 05 Adjustable and Floating Rate Mortgage Loans Solutions to Questions Chapter 5 Adjustable and Floating Rate Mortgage Loans Question 5 1 In the previous chapter significant problems regarding the ability of borrowers to meet mortgage payments and the evolution of fixed interest rate mortgages with various payment patterns were discussed Why didn t this evolution address problems faced by lenders What have lenders done in recent years to overcome these problems These inadequacies stem from the fact that although payment patterns can be altered to suit borrowers as expectations change the CAM CPM and GPM are all originated in fixed interest rates and all have predetermined payment patterns Neither the interest rate nor the payment patterns will change regardless of economic conditions A variety of mortgages are now made with either adjustable interest rates or with variable payment provisions that change with economic conditions Question 5 2 How do inflationary expectations influence interest rates on mortgage loans Most savings institutions had been making 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 savings institutions 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 5 3 How does the price level adjusted mortgage PLAM address the problem of uncertainty in inflationary expectations What are some of the practical limitations in implementing a PLAM program One concept that has been discussed as a remedy to the imbalance problems for savings institutions is the price level adjusted mortgage PLAM To help reduce interest rate risk or the uncertainty of inflation and its effect on interest rates it has been suggested that lenders should originate mortgages at interest rates that reflect expectations of the real interest rate plus a risk premium for the likelihood of loss due to default on a given mortgage loan Should prices of other goods represented in the CPI increase faster than housing prices indexing loan balances to the CPI could result in loan balances increasing faster than property values If this occurred borrowers would have an incentive to default A second problem with PLAMs has to do with the relationship between mortgage payments and borrower incomes Should inflation increase sharply it is not likely that borrower incomes would increase at the same rate in the short run During short periods the payment burden may increase and households may find it more difficult to make mortgage payments A third problem with PLAMs is that the price level chosen for indexation is usually measured on a historical basis In other words the index is based on data collected in the previous period but published currently Question 5 4 Why do adjustable rate mortgages ARMs seem to be a more suitable alternative for mortgage lending than PLAMs An ARM provides for adjustments that are more timely for lenders than a PLAM because values for r p and f are revised at specific time intervals to reflect market expectations of future values for each component of i between adjustments dates Question 5 5 List each of the main terms likely to be negotiated in an ARM What does pricing an ARM using these terms mean Initial interest rate index adjustment interval margin composite rate limitations or caps negative amortization floors assumability discount points prepayment privilege Anytime the process of risk bearing is analyzed individual borrowers and lenders differ in the degree to which they are willing to assume risk Consequently the market for ARMs contains a large set of mortgage instruments that differ with respect to how risk is to be shared between borrowers and lenders The terms listed above are features that might be used in pricing an ARM and establishing the bearing of risk 5 1 Chapter 05 Adjustable and Floating Rate Mortgage Loans Question 5 6 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 Interest rate risk is the risk that the interest rate will change at some time during the life of the loan Default risk is the risk to the lender that the borrower will not carry out the full terms of the loan agreement The fact that ARMs shift all or part of the interest rate risk to the borrower the risk of default will generally increase to the lender thereby reducing some of the benefits gained from shifting interest rate risk to borrowers Question 5 7 Which of the following two ARMs is likely to be priced higher that is offered with a higher initial interest rate ARM A has a margin of 3 percent and is tied to a three year index with payments adjustable every two years payments cannot increase by more than 10 percent from the preceding period the term is 30 years and no assumption or points will be allowed ARM B has a margin of 3 percent and is tied to a one year index with payments to be adjusted each year payments cannot increase by more than 10 percent from the preceding period the term is 30 years and no assumption or points are allowed ARM A is likely to be priced higher because it has a longer term index and adjustment period Subsequently the lender bears more risk and can expect a higher return Question 5 8 What are forward rates of interest How are they determined What do they have to do with indexes used to adjust ARM payments Forward rates are based on future interest rate expectations that are implicit in the yield curve and reveal investor expectations of interest rates between any two maturity periods on the yield curve For example the yield for a security maturing one year from now is 8 percent and the yield for a security that matures two years from now is 9 percent Based on these two yields we can compute a forward rate or rate that an investor who invests in a oneyear security can expect to reinvest funds for one additional year This forward rate will be 10 percent because if investors have the opportunity to invest today in either the one or the two year security and are indifferent between the two choices the investor buying a one year security must be able to earn 10 percent on funds available for reinvestment at the end of year 1


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