Question & Answer

Explain why some financial institutions prefer to sell the mortgages they originate. (LO4)

Describe the factors that affect mortgage prices. (LO3)

Mortgage lenders with fixed-rate mortgages should benefit when interest rates decline, yet research has shown that this favorable impact is dampened. By what? (LO3)

 Describe the shared-appreciation mortgage. (LO2)

Why are second mortgages offered by some home sellers? (LO2)

Describe the growing-equity mortgage. How does it differ from a graduated-payment mortgage? (LO2)

Describe the graduated-payment mortgage. What type of homeowners would prefer this type of mortgage? (LO2)

Explain the use of a balloon-payment mortgage. Why might a financial institution prefer to offer this type of mortgage? (LO2)

Why is the 15-year mortgage attractive to homeowners? Is the interest rate risk to the financial institution higher for a 15-year mortgage or a 30-year mortgage? Why? (LO2)

How does the initial rate on adjustable-rate mortgages (ARMs) differ from the rate on fixed-rate mortgages? Why? Explain how caps on ARMs can affect a financial institution’s exposure to interest rate risk. (LO2)

What is the general relationship between mortgage rates and long-term government security rates? Explain how mortgage lenders can be affected by interest rate movements. Also explain how they can insulate themselves against interest rate movements. (LO3)

Distinguish between FHA and conventional mortgages. (LO1)

The credit crisis was caused by the mortgage market, yet it had a serious impact on bond markets. Write a short essay on how the bond market was affected and offer your opinion on how the bond market may attempt to insulate itself from a credit crisis in the future. 

Explain why a credit crisis in one country may be transmitted to other countries. (LO5)

The Fed’s open market operations can change the money supply, which can affect the risk-free rate offered on bonds. Why might the Fed’s policy also affect the risk premium on corporate bonds? (LO2)

When stock market volatility is high, corporate bond yields tend to increase. Which market forces cause the increase in corporate bond yields under these conditions? (LO2)

Explain why systemic risk is a source of concern in the bond and other debt markets. Also explain how the Financial Reform Act of 2010 was intended to reduce systemic risk. (LO2)

Explain how the prices of bonds were affected by a change in the risk-free rate during the Covid-19 pandemic that began in 2020. Explain how bond prices were affected by a change in the credit risk premium during this period. (LO2)

Assume that you maintain bonds and money market securities in your portfolio, and you suddenly believe that long-term interest rates will rise substantially tomorrow (even though the market does not share the same view), while short-term interest rates will remain the same.

a. How would you rebalance your portfolio between bonds and money market securities? 

b. If other market participants suddenly recognize that long-term interest rates will rise tomorrow and they respond in the same manner as you do, explain how the demand for these securities (bonds and money market securities), the supply of these securities for sale, and the prices and yields of these securities will be affected.

c. Assume that the yield curve is flat today. Explain how the slope of the yield curve will change tomorrow in response to the market activity. (LO2)

Consider the prevailing conditions for inflation (including oil prices), the economy, the budget deficit, and the Fed’s monetary policy that could affect interest rates. Based on these conditions, do you think bond prices will increase or decrease during this semester? Offer some logic to support your answer. Which factor do you think will have the biggest impact on bond prices? (LO2)

Assume the yield curve experiences a sudden shift such that the new yield curve is higher and more steeply sloped today than it was yesterday. If a firm issues new bonds today, would its bonds sell for higher or lower prices than if it had issued the bonds yesterday? Explain. (LO2) 

The pension fund manager of Utterback (a U.S. firm) purchased German 20-year Treasury bonds instead of U.S. 20-year Treasury bonds. The coupon rate was 2 percentage points lower on the German bonds. Assume that the manager sold the bonds after five years. The yield over the five-year period was substantially more than the yield the manager would have received on the U.S. bonds over the same five-year period. Explain how the German bonds could have generated a higher yield than the U.S. bonds for the manager, even if the exchange rate was stable over this five-year period. (Assume that the price of either bond was initially equal to its respective par value). Be specific. (LO2, LO5)

A U.S. insurance company purchased British 20-year Treasury bonds instead of U.S. 20-year Treasury bonds because the coupon rate was 2 percentage points higher on the British bonds. Assume that the insurance company sold the bonds after five years. Its yield over the five-year period was substantially less than the yield it would have received on the U.S. bonds over the same five-year period. Assume that the U.S. insurance company had hedged its exchange rate exposure. Given that the lower yield was not because of default risk or exchange rate risk, explain how the British bonds could have generated a lower yield than the U.S. bonds. (Assume that either type of bond could have been purchased at the par value.) (LO2, LO5)

The value of the dollar is monitored by bond market participants over time.

a. Explain why expectations of a weak dollar could reduce bond prices in the United States.

b. On some occasions, news of the dollar’s weakening has not had any impact on the bond markets. Assuming that no other information offsets the weakening dollar, explain why the bond markets may not have responded to the dollar’s decline. (LO2) 

Assume that bond market participants suddenly expect the Fed to substantially increase the money supply. (LO2)

a. Assuming no threat of inflation, how would this expectation affect bond prices?

b. Assuming that inflation may result, how would bond prices be affected?

c. Given your answers to (a) and (b), explain why expectations of the Fed’s increase in the money supply may sometimes cause bond market participants to disagree about how bond prices will be affected.