Adjustable Rate Mortgage Assume the loan amount is the same as the fixed rate lo
ID: 2801916 • Letter: A
Question
Adjustable Rate Mortgage
Assume the loan amount is the same as the fixed rate loan above.
You wonder if an adjustable rate mortgage might be beneficial. You find a 3/2 product which you want to pursue.
Initial rate: 3% margin .25%, 30 year term.
End of three years, Index rises to 4.5%, margin continues.
End of five years, Index rises to 5.0% margin continues.
Answer these questions, show your work:
What is the monthly payment for the interval which begins at the end of the initial period of the loan?
What is the monthly payment for the interval which begins at the end of the first two-year interval of the loan?
Structuring the Deal
The property is a large mansion house on a main thoroughfare in a medium-sized city. It was constructed originally in 1917 to house the family of Oscar W. Flintrock, who made a fortune in mining phosphate in the local mountains. Over the years it has had a number of owners and uses including the current 8 apartments which house students from the local university. You believe you can remodel the old house into 3 office spaces with a nice reception area on the main floor. The mansion is located about 3 blocks from an expanding downtown.
After careful consideration, you decide that an option is the best approach. Explain how you would structure an option agreement to purchase the mansion. The property was most recently listed at $425,000.
The owner, Charles Flintrock, later (after he has signed the option with you) has a dream that the house is really worth $600,000.
Can he withdraw the option after it is in place?
What can you do once you have the option in place? Discuss fully.
What if in your investigation of the property, you determined that the rock used in constructing the property is in fact radio-active and would require significant and expensive clean-up?
Explanation / Answer
The Flintrock house modification initiative can be structured as being equivalent to purchasing a cal option on the underlying asset. The underlying asset being the Flintrock house in this case. A call option gives the option holder the right but not obligation to purchase the underlying asset (Flintrock House) at a fixed exercise price at a later date irrespective of the market value of the asset at that date.
In this case the house's market value = $425000 and the option exercise price =$ 600000 (as Charles Flintrock will not enter into a option at anything below the "dreamed" of price)
Since, I am the option holder (buyer) and not Mr. Flintrock, he has to honor the option in case I wish to proceed with the modification initiative.
Once the option is in place I can either exercise it if the market value of the house goes above the exercise price of $600000. Purchasing the house at $600000 when the actual market price is $425000 will not be advisable.
Since radio active rock clean up would incur additional expenses, it might not be feasible to exercise th purchase option on the house. However, if the market value of the house goes above the exercise price of $600000, the profit made by purchasing the house under the call option can be utililzed to offset the additional radio active rock clean up cost and yet make a net profit. In such a scenario exercising the option would be advisable.
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