Question

Jerry needs 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. Jerry wants a 25-year, fixedrate mortgage in the amount of $500,000 with monthly payments. Jennifer has agreed to lend Jerry the money in three months at the current market rate of 5.5 percent, which makes the monthly mortgage payment to be $3,070.44. However, Jennifer does not have $500,000 available for the loan, so she approaches Max Cabell, the president of MC Insurance Corporation, about purchasing the mortgage from her in three months. Max 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 Treasury bond futures contracts available for delivery in three months. A Treasury bond contract is for $100,000 in face value of Treasury bonds.

a) What is the most significant risk Jennifer faces in this deal? Explain. (2 points)

b) How can Jennifer hedge this risk? (2 points)

c) Suppose that in the next three months the market rate of interest rises to 6.2 percent. What will happen to the value of Treasury bond futures contracts? Will the long or short position increase in value? (2 points)

d) Suppose that in the next three months the market rate of interest falls to 4.6 percent. What will happen to the value of Treasury bond futures contracts? Will the long or short position increase in value? (2 points)

e) Are there any possible risks Jennifer faces in using Treasury bond futures contracts to hedge her interest rate risk? (2 points)

Answer 1

I can only answer first 3 questions

a. The biggest risk Jennifer faces is the Interest Rate Risk. If the Interest Rate rises and Max Cabell buys at a lower rate thus increasing the credit cost of Jennifer. If the rate increases more than the 5.5% Jennifer promised to Jerry then it would be a loss for Jennifer.

b. Jennifer can hedge the risk by taking a short position in treasury bonds. So when she sells the bond and if the interest rate rises she will have made a gain and would offset her losses in selling the mortgage and if the interest rate decreases she will lose in futures but that would be offset by selling the mortgage at higher price.

c. If the market rate of interest rises to 6.2% then the price of future contracts would decrease thus making her a profit as her short position will gain.