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Haas School of Business Professor Nancy Wallace

Real Estate Finance UGBA183 Spring 2018

Midterm Exam, March 5, 2018

The midterm is open book, open notes. You should have a laptop or financial calculator.
The total time for the exam is 80 minutes.

Please show as much of your work as possible, in order to receive partial credit.

All students must read and sign the honor pledge below, and hand in the exam booklet at
the end of the exam.

On my honor, I pledge that I have neither given nor received any aid while taking this
examination. Moreover, I have not used any device with electronic communication ability to
send or receive information during the exam period.

_____________________________
Printed Name

Further instructions for laptop users:

You must start with a clean spreadsheet. You may not use any communication facilities
(email, instant messaging, etc) until after the exam. Once your exam is completed you
should submit your completed spreadsheet electronically to bcourses. You should also
hand in the signed exam booklet.

Further instructions for calculator users:

You must write your answers in the exam booklet. For calculations, please write the
numerical answer along with the bond math and the parameter values used. You may not
use any communication facilities until after the exam.

Answer all 4 questions.

The exam booklet consists of 7 pages (so make sure you have the full booklet).
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Question 1 is 30 minutes (Assume annual payments on the loan)

Consider the following term structure of interest rates and interest rate volatility.

Maturity 1 2 3 4
Yields 5.00% 5.50% 5.70% 5.90%
Vols. 12.00% 13.00% 12.00% 11.00%

The implied binomial tree for this term structure, using a BDT term structure and
implied binomial probabilities of .5, the evolution of spot rates is:

0.05 0.067 0.079 0.087

0.053 0.060 0.071
0.045 0.058
0.047
Beg. Yr1 Beg. Yr2 Beg. Yr3 Beg. Yr4

(You read this tree as follows. It starts with the current spot market rate of .05. The
upward move in rates is across to the right (.067), while the downward move in rates
is down and to the right (.053). The same row applies to each node as you move
rightward across the tree.)

Using a backward solving price algorithm, determine the value for each of the
following. In all cases, assume the mortgages make their payments annually.

a) (10 POINTS) A non-prepayable 4-year mortgage. The mortgage has an initial

balance of $1000, a contractual coupon rate of 5.5%, and is a fixed-payment, fully
amortizing contract.
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b) (10 POINTS) A freely prepayable 4-year mortgage. The loan terms are identical
to 2a), except that the borrower can prepay at any time. When prepaying, the
borrower prepays the loan balance outstanding at the time. There are no other costs or
fees associated with prepayment.

c) (10 POINTS) The lender decides to offer the borrower the fully prepayable
mortgage. How many points should the lender charge the borrower at origination so
that the mortgage is valued at $1,000.
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Problem 2 is 15 Minutes (Assume annual payments).

As the mortgage loan officer, you are calculating the mortgage terms on an office-
building loan.
The building has a dependable annual net operating income of $150,000 annually.

Your bank requires the following conditions for loans on this type of property:
Minimum Required Debt Coverage Rate = 150%
Maximum Loan to Value Ratio = 65%.
Capitalization rate used in determining building value = 8%.
Contract mortgage rate = 5%.
Payments are based on 25-year amortization, although loan is due after 10 years.

a) (5 POINTS) Determine the maximum feasible loan size and the associated
mortgage payment.

Maximum Feasible loan size:

Associated mortgage payment:

The borrower now indicates that the loan size determined in (a) are just fine, but he
would like an ARM with the same size and the same amortization structure (25 year
amortization, loan is due after 10 years.). The ARM loan has an annual interest rate
change cap of 2 percentage points, a life of loan interest rate change cap of 4
percentage points, and an annual payment change cap of 15% (any excess earned
payment is amortized). The loan interest rate adjusts annually to the 1-Year T-Bill
Rate plus 300 basis points. The mortgage has no origination fee, no points, and no
prepayment penalty. (For the rest of this question, ignore the mortgage payment
calculated in part (a).)

You expect the following for the following 1-year Treasury bill rates.

Year 1 Year T-Bill Rate

1 1.00%
2 3.00%
3 6.00%
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b) (5 POINTS) Using these rates (and the loan amount calculated in part (a)), what
would the loan payments be for each of the loan’s first 3 years?

c) (5 POINTS) What would your loan balance be at the end of year 3?

d) (5 POINTS) What are the main risks the borrower is facing taking this ARM
contract with its balloon payment?
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Question 3 is 25 minutes (Assume annual payments)

A borrower wants to borrow $300,000 to purchase a home. The borrower received

the following two offers from the bank:
Loan A 30 year, fixed rate mortgage and has a 4.5 % contract rate, 1 point, no other
closing costs and no prepayment penalty.

Loan B 30 year, 3-1 hybrid adjustable rate mortgage with an initial rate of 3.5%.
After the first 3 years, it will adjust annually to 1-Year T-Bill rate plus 3% margin. It
also has an annual interest rate change cap of 2 percentage points, a rate change
floor of 2 percentage points, a life of loan interest rate change cap of 5 percentage
points, and an annual payment change cap of 10% (any excess earned payment is
amortized). The loan has 0 points, 1000 additional closing costs and no prepayment
penalty. You expect the following 1-Year T-Bill rates:

Year 1 Year T-Bill Rate

1 2.00%
2 3.00%
3 1.00%
4 4.00%
5 2.00%

Note: the interest rate cap on this loan applies at each change in the T-Bill rate
including the reset period from fixed to floating at year 4, so that at year 4 the
change from the fixed rate 3.5% to the floating rate (index+margin) would be
capped at 5.5%.
a) What is the annual payment on each mortgage during the first 5 years?

Loan A (10 POINTS) :

Loan B (10 POINTS) :

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b) What is the remaining balance of each loan at the end of years 3, 4, and 5?

Loan A (10 POINTS) :

Loan B (10 POINTS) :

c) (10 POINTS) If the borrower decides he wants to move out of the home after 5
years, which loan is better for him?

Question 4 is 10 minutes (short questions; each question gets equal weight)

a) (5 POINTS) Why do FRMs and ARMs have different default risk?

b) (5 POINTS) Why do commercial mortgages with contingent interest mitigate

lender’s inflation risk?