Jennifer Williamson recently received her MBA and has decided to enter the mortgage brokerage business. Rather than work for someone else, she has decided to open her own shop. Her cousin Jerry 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. Jerry wants a 25-year, fixed-rate 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 6.5 percent. Because Jennifer is just starting out, she 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.
1. What is the monthly mortgage payment on Jerry's mortgage?
2. What is the most significant risk Jennifer faces in this deal?
3. How can Jennifer hedge this risk?
4. Suppose that in the next three months the market rate of interest rises to 7.4 percent.
a. How much will Max be willing to pay for the mortgage?
b. What will happen to the value of Treasury 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 5.8 percent.
a. How much will Max be willing to pay for the mortgage?
b. What will happen to the value of Treasury bond futures contracts? Will the long or short position increase in value?
6. Are there any possible risks Jennifer faces in using Treasury bond futures contracts to hedge her interest rate risk?