Questions Exercise - Assignment Example

The borrower has to take the decision either to go with the higher fixed-rate mortgage or to borrow the money on lower but fluctuating rate. This decision of the borrower must be backed by the know-how of the interest rates (stability of the market rates) of the market. The duration of the mortgage is also a key factor to determine the borrowing decision. A fixed-payment loan allows the borrower an amount of principal. The amount of the principal and the interest are paid on equal payments (annual, semi-annually, monthly, weekly or daily).

The equal payment consists a portion of the interest rate and the principal. On the other hand the coupon bonds are acquired by paying some money initially. The owner is entitled to receive coupon payments (annually, semi-annually or others, as defined by the owner) and a face value for the coupon at the end. The coupon payment is derived by multiplying the "Face Value and Coupon Rate (FV*r)". Option 1 is same as 80,000 at both interest rates. The total present value (PV) of option 2 is decreased by (81,911-74,840=7071) and the decrease in PV of option 3 can also be observed by comparing values at interest rate of 5% and 12%.

At higher interest rates the present value received every year decreases (increase in interest rates causes the PV to decrease). The best possible way to minimize the risk would be to invest in B and C (as there lie a perfect negative correlation). The expected value is also same for both B & C. If investment in B does not perform well the investment C will perform well. The expected value is guaranteed and the element of risk is negligible. (b) By adding in your investment an additional $1,000, the Expected Value will be doubled (EV= .

5*(1600-1000) + .5*(2800-1000) =1200 or 20%). The SD is also doubled [(.5*(600-1200)^2 + .5*(1800-1200)^2]^1/2 =600). If the borrowed amount is increased to $2,000 and the total investment is now $3,000 the