CAPITAL MARKETS:

the Mortgage market

 The mortgage market: what are mortgages?
A mortgage is a long-term loan secured by real estate.

A company may obtain a mortgage loan to

finance the construction of an office building,
or a family may obtain a mortgage loan to
finance the purchase of a home.
 Mortgages: characteristics
Characteristics of the Mortgage:
1. Principal: The principal is the total amount of the loan given. For example, if an individual takes out a
€250,000 mortgage to purchase a home, then the principal loan amount is €250,000.

2. Mortgage interest rates:The interest rate borrowers pay on their mortgages.

➢ Markets rates (e.g., The Euribor (Euro Interbank Offered Rate) is the interest rate used as an indexing parameter
for variable rate mortgage loans)
➢ Spread

E.g., Mortgage interests rate: Euribor 1% + Bank spread 2% = 3%

EURIBOR trend (2000-2020)
 Mortgages: characteristics
Characteristics of the Mortgage:
3. Loan terms
➢ Collateral
➢ Private mortgage insurance
➢ Terms (maturity date: 15, 20, 30 years)
➢ Discount points: payments made at the beginning of a loan.

4. Mortgage loan amortization: Amortization is paying off a debt over time in equal installments.
Borrowers agree to pay a monthly amount of principal and interest that will fully amortize the loan by
its maturity.
 Mortgages: main types
Main type of mortgage loans:

Fixed and adjustable rate mortgages

➢In fixed-rate mortgages, the interest rate and the monthly payment do not vary over the life of
the mortgage.

➢The interest rate on adjustable-rate mortgages (ARMs) is tied to some market interest rate and
therefore changes over time.
 The mortgage market
➢ In general, lenders make loans and hold them until the maturity date in order to receive interest
payments (originate-to-hold model). However, once a loan has been made, many lenders immediately
sell the loan to another investor such as pension funds, insurance companies, and hedge funds
(originate to distribute model).
A bank that made a mortgage loan can sell the loan in the secondary mortgage market, which is a
market where investors can buy and sell previously-issued mortgage loans.

➢ADVANTAGES: By selling a loan, the originator frees up funds (more liquidity) that can be lent to
another borrower, thereby generating additional income, and transfers credit risk (reducing risks) to
investors.
 The mortgage market: the securitization
➢An alternative to selling mortgages directly to investors is to create a new security backed by a large number
of mortgages assembled into what is called a mortgage pool.
▪ This process is called securitization: the process of transforming otherwise illiquid financial assets (such as residential mortgages) into marketable capital
market securities.

Specifically, securitization is the process whereby illiquid

assets (e.g., a mortgage) are pooled and transformed into
tradeable and interest-bearing financial instruments that
are sold to investors. As a consequence, interest and
principal payments from the assets are passed to investors
to through a special purpose entity.

Securitization provides lenders with liquidity and it

represents an effective means of diversifying their
portfolios to reduce risk.
 Derivatives markets
➢The derivatives market refers to the financial market for financial derivatives.

➢ They are financial instruments whose value derived from the value of the underlying financial
instruments.

➢They can be based on different types of assets, such as equity and commodities, interest rates,
indexes and so on.
 Derivatives markets:
Financial Derivatives:

1. Options: financial derivative contracts that give the buyer the right, but not the obligation, to buy or sell an underlying
asset at a specific price (referred to as the strike price) during a specific period of time.
For example, assume a trader buys one call option contract on ABC stock with a strike price of $25. He pays $150 for the
option. On the option’s expiration date, ABC stock shares are selling for $35. The buyer/holder of the option exercises his
right to purchase 100 shares of ABC at $25 a share (the option’s strike price). He immediately sells the shares at the current
market price of $35 per share. He paid $2,500 for the 100 shares ($25 x 100) and sells the shares for $3,500 ($35 x 100).
His profit from the option is $1,000 ($3,500 – $2,500), minus the $150 premium paid for the option. Thus, his net profit,
excluding transaction costs, is $850 ($1,000 – $150). That’s a very nice return on investment (ROI) for just a $150
investment.
 Derivatives markets:
Financial Derivatives:

2. Futures: standardized contracts that allow the holder of the contract to buy or sell the respective underlying asset at
an agreed price on a specific date. The parties involved in a futures contract not only possess the right but also are
under the obligation, to carry out the contract as agreed.

3. Forwards: they are similar to futures contracts in the sense that the holder of the contract possess not only the right
but is also under the obligation to carry out the contract as agreed. However, forwards contracts are over the counter
products, which means they are not regulated and are not bound by specific trading rules and regulations.

4. Swaps: derivative contracts that involve two holders, or parties to the contract, to exchange financial obligations.
Interest rate swaps are the most common swaps contracts entered into by investors.
 Derivatives markets:
Motivations behind transactions in financial derivatives:
1. Financial speculation involves the buying, holding, selling, and short-selling of stocks, bonds, commodities,
currencies, real estate, derivatives, or of any other financial instrument, in order to profit from fluctuations
in its price.
2. Hedging involves engaging in a financial transaction that offsets a long position by taking an additional
short position, or offsets a short position by taking an additional long position, with the aim is to remove
unwanted risk while still allowing some profit to be made from the transaction.
3. Arbitrage is the strategy of taking advantage of price differences in different markets for the same asset.
For it to take place, there must be a situation of at least two equivalent assets with differing prices. The
simplest form of arbitrage is purchasing an asset in the market where the price is lower and simultaneously
selling the asset in the market where the asset’s price is higher.