EXGA 6113Assignment 2A (Optional) Dr Lim Ewe Ghee Semester I, 2011

1. The Oddball Mortgage Company offers unusual mortgages. One kind is a zero

interest rate 30-year mortgage. What is the monthly payment on a $1000 mortgage? Another is a two-month mortgage with an annual interest rate of 1200%. Its first payment is one month from now, its second and last payment is two months from now. What is the monthly payment on a $1000 mortgage? Show your work.

2. The Jones family is looking to buy a house; their real estate agent asks them

what the maximum price they will pay for a house is. They say they will pay a down-payment of 20 percent of the price of the house; and the most they can pay per year is 30 percent of their annual income of $90,000. Suppose they take out a 3-year loan at 10 percent; and they make only one payment per year. What is the maximum amount they can pay for a house?

3. Your classmate, Asraf, asked a question about how risk premiums can increase during recessions while interest rates fall. I explained it in class before the first midterm but I am not sure the class fully understood the explanation. I am going to guide you through the answer and I want you to use graphs to explain the answer. First, note that: (rp) Risk premium = R(c) R(T) where R(c) = rate on corporate bonds; R(T) = rate on Treasury bonds; Since risk premium involves two different types of bonds, we need to draw the supply and demand graphs for each type of bond. Start by drawing one graph for the corporate bond market and one graph for the Treasury bond market. Let the equilibrium price for the corporate bond be lower than that for Treasury bonds, that is: p*(c) is less than p*(T) so that rp = R*(c) R*(T). Now work on the market for corporate bonds. Suppose we now have recessionary conditions. Show what happens in the corporate bond market, using the usual analysis. The new equilibrium price for corporate bonds p**(c) is now lower than p*(c). Now consider what happens to the Treasury bond market. Since the new equilibrium price for corporate bonds is lower than before (and the new equilibrium corporate interest rate is higher than before), corporate bonds are now more attractive than Treasury bonds (where we have changed nothing so far). Investors will now shift from Treasury bonds to corporate bonds. Demand for Treasury bonds fall and

demand for corporate bonds rise. At the new final equilibrium, both corporate and Treasury bond interest rates are lower than before the recession, but the risk premium is greater than before (because in recessions, corporate bonds are riskier; more bankruptcies). That theoretically is our new equilibrium. Draw the graphs for the two markets so that we have the new equilibrium prices (interest rates). You need to show 4 graphs2 before the recession; and 2 during the recession. 4. Read the report below FROM CNBC.COM on Wednesday, Nov 2, 2011 Financial stocks were among the hardest hit on Tuesday, with declines of 5 to 8 percent for the big banks like Goldman Sachs [GS 103.54 -6.01 (-5.49%) ], Citi [C 29.17 -2.42 (-7.66%) ] and Morgan Stanley [MS 16.23 -1.41 (-7.99%) ], as investors feared the extent of their exposure to Europe's financial crisis. But those fears have been overdone, according to analysts like Dick Bove of Rochdale Securities, who believes American banks' exposure to Europe's debt crisis is limited and banking stocks are now "so cheap", investors should be aggressively buying them. Stocks like Citi, for example, are trading at a low price-to-book (P/B) value of 0.57, while Morgan Stanley is trading at a P/B ratio of 0.72, suggesting the shares are undervalued. Cumberland Advisors' Kotok agrees. "There was a time a few weeks ago when you could buy the entire banking sector of the United States at the market prices at which they traded, below their tangible book value. In other words, the liquidation value, that's cheap. Any time in history when you could get banks below book value, it's been an entry point, not a time to sell them, and that's how they're trading now," Kotok said. "Not just the big banks, but smaller banks, mid-sized banks, regional banks, the banking system is at a fire sale price." The S&P Financial Index, which tracks major U.S. banking stocks, has sold off nearly 20 percent this year, considerably worse than the S&P 500's 3 percent decline for the year. "In this sell-off, we're back in," Kotok said, with further upside for the sector supported by an improving U.S. economic outlook.
a) Book value is what you could get if the company were sold. Price-book (P/B)

value is another ratio used to determine whether a stock is cheap or expensive. Since the P/B is less than one, it means you will be paying less for the bank than the value of the bank (at historical cost). For that reason, these analysts say that banks are undervalued and you should buy banks now. Are these analysts right? What do you think? (just a few sentences). What would the Efficient Market Hypothesis (EMH) say? b) If EMH were wrong, would you expect a boom in financial stock prices by the time you get these questions? Well, has there been a boom in financial stock prices in the U.S the last few days?