C.

Mortgage Markets and Derivatives

1. Describe What are Mortgages and Mortgage Market?

Mortgage is a debt instrument, secured by the collateral of specified real estate property that the
borrower is obliged to pay back with a predetermined set of payments. Usually businesses and
individuals use mortgages to make large real estate purchases without paying the entire purchase price
up front. Over many years, the borrower repays the loan, plus interest, until he completes the payment
and owns the property. Then in case of failure of the payment, the bank may take the possession of the
said property.

The mortgage market is split into two main components

a. Primary mortgage market - is the market where borrowers can obtain a mortgage loan from a
primary lender. Banks, mortgage brokers, mortgage bankers, and credit unions are all primary lenders
and are part of the primary mortgage market and homeowners can deal directly with primary lenders
when shopping for a mortgage loan by contacting their local bank.

b. The secondary mortgage market - is a market where mortgage loans and servicing rights are
bought and sold by various entities.

2. Enumerate different types of Mortgage Loans and provide brief explanation for each.

Types of mortgage loan

A. Conventional Mortgages- conventional mortgages are originated by banks but are not guaranteed by
government and are great choice for many homeowners, because they offer lower cost than some other
popular load types. If you have a high enough credit score and large enough down payment,
conventional mortgage might be right for you.

B. Insure Mortgages- Insure mortgage are originated by banks or other mortgage lenders but are
guaranteed by either the government or government controlled entities.

C. Fixed-rate Mortgages- It is a loan with a fixed interest rates, provides payment stability. The interest
rate and the monthly payment do not vary over the life of the mortgage.

D. Adjustable-Rate Mortgages- It is a type of mortgage in which the interest rate applied on the
outstanding balance varies throughout the life of the loan. The interest rate on ARMS is tied to some
market interest rate and therefore changes over time.

E. Graduated-Payment Mortgage- These mortgage are useful for home buyers who expect their incomes
to rise. It has a lower payment on the first few years then the payments rise.

F. Shared Appreciation Mortgage- The lender lowers the interest rate in the mortgage in exchange for a
share of any appreciation in real state (if the property sells for more than a stated amount, the lender is
entitled to a portion of the gain).

G. Equity Participating Mortgage- An outside share in the appreciation of the property. Then, as with the
SAM, the borrower benefits by being able to qualify for a large loan without such help.
H. Second Mortgages- A type of subordinate mortgage made while an original mortgage is still in effect.
In the event of default, the original mortgage would receive all proceeds from the liquidation of the
property until it is all paid off. A second mortgage is a loan made in addition to the homeowner's
primary mortgage.

I. Reverse Annuity Mortgages- The bank advances funds to the owner on a monthly schedule to enable
him to meet living expenses he thereby increasing the balance of the loan which in secured by the real
estate. When the borrower dies, the real estate sells the property to pay the debt.

J. Growing Equity Mortgage- The payments will initially be the same a on a conventional mortgage. Over
time, however, the payment will increase. Initial payment increases each year and loan amortized in less
than 30 years.

3. Enumerate and explain the important factors that affect the interest rate of the loan.

One of the most important factors that affects the decision of a borrower is the interest rate of the loan.
However, there are three important factors that affects the interest rate of the loan.

First is the current long-term market rates which are determined by the movement in the supply and
demand for long-term funds, which are in turn, affected by a number of global, national and regional
factors.

Second factor is the term or life of the mortgage. Long-term mortgages have higher interest rates than
short-terms. The usual mortgage lifetime is 15 or 30 years. Interest rate risk falls as the term to maturity
decreases, so the interest rate on the 15-year loan is substantially less than that of the 30-year loan.

Third or the last factor is the number of discount points paid. This discount points are the payments
made at the beginning of a loan. One discount points means a payment of 1% loan amount at closing. In
exchange for the points, a lender reduces the interest rate on the loan.

4. Enumerate the characteristics that a borrower may consider in securing residential mortgage.

A residential mortgage is a large long term loan taken out by one or more individuals to buy a home to
live in. With a residential mortgage the home must be used as a residence by the borrowers, not rented
out to tenants or used for commercial purposes. A residential mortgage is secured against the home to
protect the lender’s money. This means that if repayments are consistently not met and a borrower
defaults on paying the mortgage the lender has a claim on the home. Residential Mortgage
Characteristics: Federal insurance guarantees repayment in the event of borrower default, Limits on
amounts, borrower requirements, Borrower pays insurance premiums, and If interest rates rise in the
market, lender’s cost of funds increases with no matching increase in return. Secured loans tend to offer
lower interest rates than unsecured loans, making secured loans a good choice for borrowers on a tight
budget. Secured loans also typically allow borrowers to get a bigger loan amount than with an
unsecured loan, giving the secured loan borrower expanded financial options, although with more
financial risk in the form of potentially lower secured loan repayment periods.

5. What are Derivatives and enumerate typical examples of Derivatives.

Derivatives are financial instruments that “derive” their value on contractually required cash flows from
some other security or index. A derivative is an instrument whose value is derived from the value of one
or more underlying, which can be commodities, precious metals, currency, bonds, stocks, stocks indices,
etc. They are complex financial instruments that are used for various purposes, including hedging and
getting access to additional assets or markets.

Four most common examples of derivative instruments are Forwards, Futures, Options and Swaps.
Forward Contract is similar to futures contract. Forward contact calls for delivery on a specific date while
Futures contract permits the seller to decide later which specific day within the specified month will be
the delivery date. Unlike Futures contract, forward contact is not usually traded on a market exchange
and does not call for a daily cash settlement for price changes in the underlying contract. Options
provide the buyer of the contracts the right, but not the obligation, to purchase or sell the underlying
asset at a predetermined price. Swaps are derivative contracts that allow the exchange of cash flows
between two parties. The swaps usually involve the exchange of a fixed cash flow for a floating cash
flow. The most popular types of swaps are interest rate swaps, commodity swaps, and currency swaps.