ARE144_chap_05_bf13ed_v2

ARE144_chap_05_bf13ed_v2 - 1 Managerial Economics (ARE) 144...

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1 Managerial Economics (ARE) 144 University of California, Davis Instructor: John H. Constantine Handout: Chapter 5, Adjustable Rate and Variable Payment Mortgages (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? (2) How do inflationary expectations influence interest rates on mortgage loans? (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? (4) Why do adjustable rate mortgages (ARMs) seem to be a more suitable alternative for mortgage lending than PLAMs? (5) List each of the main terms likely to be negotiated in an ARM. What does pricing an ARM using these terms mean? (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? (7) Which of the following two ARMs is likely to be priced higher, that is, offered with a higher initial interest rate? (a) 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. (b) 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. (8) What are forward rates of interest? How are they determined? What do they have to do with indexes used to adjust ARM payments? (9) Distinguish between the initial rate of interest and expected yield on an ARM. What is the general relationship between the two? How do they generally reflect ARM terms? (10) If an ARM is priced with an initial interest rate of 8 percent and a margin of 2 percent (when the ARM index is also 8 percent at origination) and a fixed rate mortgage (FRM) with constant payment is available at 11 percent, 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 percent?
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This note was uploaded on 03/14/2012 for the course ARE 144 taught by Professor Johnson,e during the Spring '08 term at UC Davis.

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ARE144_chap_05_bf13ed_v2 - 1 Managerial Economics (ARE) 144...

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