MORTGAGE
MARKETS AND
DERIVATIVES
CHAPTER 10
OBJECTIVES
Understand the role and function of mortgage
markets.
Define what mortgages are and their purpose.
Identify and explain the key factors that influence
loan interest rates.
Differentiate between various types of mortgages,
such as:
Conventional vs. Insured Mortgages
Fixed-rate vs. Adjustable-rate Mortgages
Graduated-payment vs. Growing-equity Mortgages
Explain the concept of derivative financial
instruments.
Distinguish between the use of derivatives for
hedging and for speculation.
MORTGAGE MARKETS
MORTGAGES
long-term loan secured by real estate. Both individuals and businesses obtain mortgages
loans to finance real estate purchases.
MORTGAGE MARKET
where borrowers - individual businesses and governments can obtain long-term
collaterized loans.
Subcategory of the capital market because mortgages involve long-term funds.
Borrowers in the capital markets are businesses and government
entities, whereas the usual borrowers in the mortgage markets are
individuals.
Mortgage loans are made for varying amounts and maturities,
depending on the borrowers' needs, features that cause problems for
developing a secondary market.
CHARACTERISTICS OF THE RESIDENTIAL
MORTGAGE
A. MORTGAGE INTEREST RATE
One of the most important factors in the decision of the borrower of how much
and from whom to borrow is the interest rate on the loan.
Three important factors that affect the interest rate on the loan:
1. Current long-term market rates 2. Term or life of the mortgage 3. Number of Discount Points Paid
These rates are influenced by Longer loans (like 30 years) usually Discount points are fees you
the overall supply and demand have higher rates than shorter loans pay upfront to reduce your
for money. interest rate.
(like 15 years). Lenders see shorter
loans as less risky, so they offer
lower rates for them.
CHARACTERISTICS OF THE RESIDENTIAL
MORTGAGE
B. LOAN TERMS
contain many legal and financial terms, most of which protect the
lender from financial loss.
C. COLLATERAL
One characteristic common to mortgage loans is the requirement that
collateral, usually the real estate being financed, be pledged as
security.
CHARACTERISTICS OF THE RESIDENTIAL
MORTGAGE
D. DOWNPAYMENT
Down payments (like liens) are intended to make the borrower less likely to
default on the loan.
E. PRIVATE MORTGAGE INSURANCE (PMI)
an insurance policy that guarantees to make up any discrepancy between
the value of the property and the loan amount, should a default occur.
F. BORROWER QUALIFICATION
Qualifying for a mortgage loan is different from qualifying for a bank loan
because most lenders sell their mortgage loans to one of a few government
agencies in the secondary mortgage market.
AMORTIZATION OF
MORTGAGE LOAN
Mortgage loan borrowers generally agree to pay a monthly amount of principal and interest that will be
fully amortized by its maturity. "Fully amortized" means that the payments will pay off the outstanding
indebtedness by the time the loan matures.
TYPES OF MORTGAGE LOANS
CONVENTIONAL MORTGAGE LOAN VS INSURED MORTGAGE
Conventional mortgage loan insured mortgage
Guarantee None Guaranteed
Usually private mortgage
Additional Requirements None
insurance
Downpayment 5% - 20% Low or Zero
TYPES OF MORTGAGE LOANS
ADJUSTABLE-RATE MORTGAGE (ARM) VS FIXED-RATE MORTGAGE
ADJUSTABLE=RATE MORTGAGE (ARM) FIXED-RATE MORTGAGE
Changes over time (tied to some
Interest Rate (over the term of Does not vary, as well as monthly
market interest rate / other
the loan/life of the mortgage) payments
security)
Adjusted periodically, size - subject
Adjustments None
to annual limits
Limits CAPS - high/low None
TYPES OF MORTGAGE LOANS
GRADUATED-PAYMENT MORTGAGE (GPM) VS GROWING-EQUITY
MORTGAGE (GEM)
GPM GEM
Initially same as conventional
Payments Initially lower
mortgages
Increase in payments Yes Yes
Amortization 30 years Less than 30 years
TYPES OF MORTGAGE LOANS
SHARED-APPRECIATION MORTGAGE (SAM) VS EQUITY
PARTICIPATION MORTGAGE
SAM EPM
A portion of the downpayment /
Exchange Lower interest rate
Monthly payment supply
Lender (receives a portion of the
Who shares the appreciation in
gain) Outside investor
value of the real estate
(if SP > Stated Amount)
Borrower (able to qualify for larger Investor (receives a portion of any
Beneficiary
loans) appreciation of the property)
TYPES OF MORTGAGE LOANS
SECOND MORTGAGE
The loan is secured by a second lien (same real estate agent as the first
mortgage)
Often, for a line of credit or home improvement loans
A junior to the original loan
If there is a default,
Payment: First Loan > Second Loan (if sufficient funds remain)
TYPES OF MORTGAGE LOANS
REVERSE ANNUITY MORTGAGES (RAM)
LENDER disburses monthly payments to the BORROWER = increasing-
balance loan
Loan = due only when real estate is SOLD
Borrower = does not make payments
When the borrower dies = property is sold to pay the debt
SECURITIZATION OF MORTGAGES
Mortgage-backed securities (MBS) are created
through a process called securitization, where a
pool of mortgage loans is assembled and interests
in the pool are sold to investors. Securitization
makes the mortgage market more liquid and
provides funds for additional lending.
ADVANTAGES OF
SECURITIZATION:
DISADVANTAGE:
Eliminates local economic risk
for originators
Allows access to national capital
Interest rates become
markets more volatile due to
Reduces lender’s risk
market sensitivity
Mortgage interest rates become
more reflective of market
conditions
Derivatives
A DERIVATIVE IS A FINANCIAL INSTRUMENT
THAT DERIVES ITS VALUE FROM THE
DIFFERENCE INHERENT IN AN UNDERLYING
PRIMARY INSTRUMENT BETWEEN THE
CONTRACTING PARTIES, WITHOUT ANY NEED
TO TRANSFER THE UNDERLYING INSTRUMENTS
THEMSELVES (EITHER AT INCEPTION OF THE
CONTRACT OR EVEN, WHERE CASH SETTLED,
OR TERMINATION).
DERIVATIVE FINANCIAL
INSTRUMENTS
CHARACTERISTICS OF
DERIVATIVES
HOW IT WORKS
Investors may buy derivatives in order to reduce the
amount of volatility in the value of that asset, or to try
to increase their gains through speculation.
Derivatives can enable an investor to gain exposure to
a market via a smaller capital requirement than if they
bought the actual underlying asset.
DERIVATIVES FOR DERIVATIVES FOR
HEDGING SPECULATION
Companies use derivatives to protect against Speculators are people who try to
cost fluctuations by fixing a price for a future
make a profit by taking a view on
deal in advance. By settling costs in this way,
buyers gain protection known as a which way prices will move and
hedgeagainst unexpected rises or falls in then buying or selling financial
instruments accordingly.
for example, the foreign exchange market,
interest rates, or the value of the commodity
or product they are buying.
RISKS OF DERIVATIVES
Market Risk – The risk of losses due to unfavorable market
movements.
Credit Risk – The risk that a counterparty will default on its
contractual obligations.
Liquidity Risk – The risk that a derivative position cannot be
sold or closed quickly without a significant loss in value.
Operational Risk – The risk of loss from inadequate or failed
internal processes, systems, or external events.
TYPES OF DERIVATIVES
Forward Contracts Futures Contracts
A forward contract is an Futures are standardized forward
agreement between two parties contracts traded on exchanges.
to buy or sell an asset at a They obligate the buyer to
specified future date for a price purchase, and the seller to sell, an
agreed upon today. Forwards are asset at a predetermined future
private agreements and are date and price.
customizable. Futures are regulated and involve
margin requirements.
TYPES OF DERIVATIVES
Options Contracts Interest Rate Swaps
Options give the holder the right, Swaps are agreements between
but not the obligation, to buy (call two parties to exchange
option) or sell (put option) an asset sequences of cash flows for a set
at a specific price within a period of time.
specified time period. The most common types are
The seller of the option has the interest rate swaps and currency
obligation to fulfill the contract if swaps.
the buyer chooses to exercise the
option.
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