Dr. P.V. Viswanath
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LUBIN SCHOOL OF BUSINESS
Fin 301 Introduction to Financial Management
Prof. P.V. Viswanath
1. (20 points) Pfizer Inc. has a beta of 0.433 according to Yahoo.
2. (20 points) Answer the following questions.
3. (15 points) You have bought a car for $20,000. Now it's time to pay for it! And you only have $2000 for a downpayment. Fortunately, the car dealer is willing to lend you the rest of the money. If the dealer's opportunity cost is 15% p.a. (i.e. investing $100 today will yield him $115 at the end of the year), how much would you have to pay every quarter, if the dealer requires you to make 20 equal quarterly payments?
4. Read the following article, "Lenders Retool Long-Term Mortgages" from the Wall Street Journal of June 16, 2005 and answer the following questions:
Lenders Retool Long-Term Mortgages
The mortgage industry is starting to make the move from short to long.
Lenders are rolling out a new crop of 30-year fixed-rate mortgages that let homeowners make low, interest-only payments for as long as 10 or 15 years. It is the latest effort to snare borrowers seeking lower monthly payments. Also getting a new push: mortgages that stretch for as long as 40 years.
The newest crop of products is largely aimed at borrowers who are looking
for lower payments but are also concerned about interest-rate risk. In
recent months, mortgage experts have been surprised by the continued strong
interest in adjustable-rate mortgages at a time when borrowers can still
lock in a fixed-rate loan at rates well below 6%. With rising short-term
interest rates reducing the relative attractiveness of adjustable loans,
lenders are seeing greater interest in loans that protect borrowers from
rising interest rates -- and are introducing products for that market.
Forty-year mortgages -- which keep monthly payments down but cost more over the long term -- also are attracting more notice in the wake of Fannie Mae's recent decision to expand its purchases of these loans. First offered in the 1980s, 40-year loans account for less than 1% of mortgage originations, according to the Mortgage Bankers Association. More banks may be willing to offer them now that they know they can be sold to Fannie Mae, which has been purchasing 40-year mortgages since September 2003 under a pilot program with 22 credit unions. Fannie will purchase both fixed- and adjustable-rate 40-year mortgages.
Next month, IndyMac Bancorp will reintroduce its 40-year mortgage, which was mothballed last year because of a lack of interest. Fannie Mae's move "helps by bringing attention to the product and credibility to it," says IndyMac Executive Vice President Frank Sillman. "It also brings a host of investors that will purchase 40-year loans." Washtenaw Mortgage Co. in Ann Arbor, Mich., a unit of Washtenaw Group, began offering these loans in May. Old National Bancorp. in Evansville, Ind., says it will add them this summer.
Some lenders have been offering more and more interest-only mortgages in recent years to eager borrowers, though the vast majority of them have been adjustable-rate loans with interest-only features. These include both short-term adjustables, with rates that can adjust as often as once a month, and so-called hybrid ARMs that can carry a fixed rate for as long as 10 years, after which the rate can adjust annually.
ARMs and interest-only mortgages have been especially attractive to borrowers looking to keep their monthly payments down in the face of skyrocketing home prices. These loans accounted for nearly two-thirds of mortgage originations in the second half of last year, according to the Mortgage Bankers Association. Among the increasingly popular choices: so-called option ARMs, which are short-term ARMs that carry introductory rates of as low as 1% and give borrowers multiple payment options. Because these loans allow borrowers to afford more house with a lower payment, some observers worry that they have helped fuel a heated housing market.
The growing popularity of interest-only and adjustable-rate mortgages has also raised fears that borrowers and lenders are taking on additional risks that could create problems down the road. "The apparent froth in housing markets may have spilled over into mortgage markets," Federal Reserve Chairman Alan Greenspan told Congress last week. He called the "dramatic increase in the prevalence of interest-only loans, as well as the introduction of other relatively exotic forms of adjustable-rate mortgages ... developments of particular concern."
Lenders that now offer fixed-rate loans with interest-only features say they have seen a spurt of interest in these products in recent weeks as the yield curve has flattened, making ARMs relatively less attractive. At Greenpoint Mortgage, a unit of North Fork Bancorporation Inc., interest-only loans now account for about 30% of fixed-rate mortgages, up from 15% earlier this year. Countrywide Financial Corp. says activity in fixed-rate interest-only mortgages has been "brisk" recently.
Because they allow borrowers to lower their monthly payments, the newer breed of mortgages is aimed at homeowners concerned about affordability and those who want to free up cash for other purposes. Unlike ARMs, which allow borrowers to get a lower rate in exchange for accepting the risk of future rate increases, fixed-rate interest-only mortgages carry the same interest rate over the life of the loan.
But like other interest-only loans, they tend to be more costly than standard mortgages. At Countrywide, the interest rate on an interest-only loan is typically one-eighth of a percentage point higher than the rate on a comparable loan without the interest-only feature. Wells Fargo says its borrowers typically pay about one-quarter point more in upfront costs -- or $500 on a $200,000 mortgage.
Borrowers can face payment shock when the interest-only period ends. A borrower with a $200,000, 5.50% 30-year mortgage that's interest-only for the first 15 years would see the monthly payment increase to $1,634 from $917 when the loan recasts so that the mortgage can be paid off in the remaining years, according to HSH Associates in Pompton Plains, N.J.
Some lenders and borrowers are looking to 40-year mortgages as an alternative to interest-only mortgages. The 40-year loans are likely to appeal to borrowers "in the middle of the country, who tend to be more conservative," says James Cotton, vice president for single-family marketing at Freddie Mac, which is looking at buying 40-year mortgages.
Forty-year mortgages can be costly over the long haul. Rates on these loans tend to be about 0.25 to 0.375 percentage point higher than the rate on a comparable 30-year mortgage. Borrowers also pay more interest over time because the loan is stretched over an additional 10 years. With a $200,000 mortgage with a 5.75% fixed rate, a borrower with a 40-year mortgage will pay roughly $312,000 in interest over the life of the loan, according to HSH Associates, versus about $220,000 in interest if the same loan has a 30-year term, assuming both loans carry the same interest rate. If the rate on the 40-year mortgage is 6%, the total interest payments jump to about $328,000.
Some lenders are tweaking the formula. Hingham Institution for Savings in Hingham, Mass., last year introduced a 20-20 mortgage, a 40-year loan with a single rate adjustment after the first 20 years. Because it is essentially two 20-year loans, the rate on the mortgage is one-quarter to one-eighth of a point below the rate on a standard 30-year loan. "It's been our most popular product," says Hingham vice president Michael Sinclair.
5. (20 points) You have constructed the following probability distribution of returns on Countrywide Financial Corp's stock over the next year: