Jennifer McAfee recently received her university Master’s degree 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 Finn has approached her about a mortgage for a house he is building. The house will be completed in 3 months, and he will need the mortgage at that time. Finn wants a 25-year, fixed-rate mortgage for the amount of £500,000 with monthly payments. Jennifer has agreed to lend Finn the money in 3 months at the current market rate of 8 per cent. Because Jennifer is just starting out, she does not have £500,000 available for the loan, so she approaches Ian MacDuff, the president of IM Insurance, about purchasing the mortgage from her in 3 months. Ian has agreed to purchase the mortgage in 3 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 3 months. There are Treasury bond futures contracts available for delivery in 3 months. A Treasury bond contract is for £100,000 in face value of Treasury bonds.
1. What is the monthly mortgage payment on Finn’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 3 months the market rate of interest rises to 9 per cent. (a) How much will Ian 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 3 months the market rate of interest falls to 7 per cent. (a) How much will Ian be willing to pay for the mortgage? (b) What will happen to the value of T-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?
7. IM Insurance wish to hedge themselves against interest rate risk by ensuring that the average duration of their assets equals the average duration of their liabilities. This strategy is known as duration matching or portfolio immunization. Explain how duration matching can protect a portfolio of assets and liabilities against a shift in interest rates.
8. Describe a situation when the duration of assets doesn’t match the duration of liabilities. When do you make a profit (loss) on your portfolio?
9. In which situation does duration matching fail to perfectly immunize a portfolio?