Question

Hello, Thanks for providing an original solution to the following mini case...

-.Johnson Mortgage Inc.

...Danielle Johnson 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 Paul 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. Paul wants a 25-year, fixed-rate mortgage in the amount of $400,000 with monthly payments.

Danielle has agreed to lend Paul the money in three months at the current market rate of 6 percent. Because Danielle is just starting out, she does not have $400,000 available for the loan; so she approaches William Wheaton, the president of IT Insurance Corporation, about purchasing the mortgage from her in three months. William 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 Government of Canada bond futures contracts available for delivery in three months. A Government of Canada bond contract is for $100,000 in face value of ten-year Government of Canada bonds.

Questions

1. What is the monthly mortgage payment on Paul's mortgage?

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

3. How can Danielle hedge this risk?

4. Suppose that in the next three months the market rate of interest rises to 7 percent.

   1. How much will William be willing to pay for the mortgage?

   2. What will happen to the value of Government of Canada bond futures contracts? Will the long or short position increase in value?

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

   1. How much will William be willing to pay for the mortgage?

   2. What will happen to the value of Government of Canada bond futures contracts? Will the long or short position increase in value?

6. Are there any possible risks Danielle faces in using Government of Canada bond futures contracts to hedge her interest rate risk?

Answer 1

Answer1: monthly mortgage payment on Paul's mortgage= (400,000 + 6%x400,000)/25x12 = $2133.33

Answer2: Interest Rate Risk.

Danielle has agreed to lend Paul the money in three months at the current market rate of 6 percent.

William has agreed to purchase the mortgage at the market rate in three months. So, if the market interest rate decreases, Danielle will suffer loss as the mortgage will be sold to william at lower value.

There is also Credit Default Risk as Paul may default the 25 year monthly payments.

Answer3: Danielle can into short position of 4 contracts of $100,000 bonds. If interest rate decreases, the bonds can still be sold at higher prices to compensate loss in mortgage value.

Answer4

(a): If market rate is 7%

monthly payment = $2266.66

(b) When market interest rate increases to 7%, having a short position in bonds will be profitable.

Answer5 market rate decreases to 5%

a) monthly payment = $2,000

b)Value of Future contracts will increase. Having a long position today will be profitable.

c) Government Default Risk. It is almost negligible. Another risk if of Liquidity Risk. There may be instances where margin calls have to be met failing which the entire futures contract may be violated.