Exhibit 1.

Calculating the debt service

PV=-500,000 , i=7/12, n=300, FV=0 CMPT Pmt= 3533.89599
Calculating the mortgage value at end of 11 th year
Pmt=3533.89599, i=7/12, n=168, FV=0 CMPT PV= -377,794.9476
Taking into consideration the 5 point deduction and calculating the APR
PV=-475,000, Pmt=3533.89599, n=132,FV=377,794.9476 CMPT i=0.64524 * 12=
7.7428%

Exhibit 2.
APR =7.7428%
EAY= (1+y/12)^12 1
Replacing the value to Y= 0.077428 in the equation above,
EAY= (1+0.077428/12)^12 -1 = 0.080236 = 8.0236%
Also,
BEY = 2((1+y/12)^6 -1)
Replacing the value to Y= 0.077428 in the equation above,
BEY= 2((1+0.077428/12)^6 -1 = 0.078688 = 7.8688%

Exhibit 3.
Calculating the Debt service while points are financed along the loan
PV=-525,000, i= 7/12, n=300,FV=0 CMPT Pmt = 3710.591
Calculating the mortgage value at end of 11 th year
Pmt= 3710.591, i=7/12, n=168, FV=0, CMPT PV= -396,684.695
Taking into consideration the 5 point financed along the loan, calculating the APR
PV=-500,000, Pmt=3710.591, n=132, FV=396,684.695 CMPT i=0.6421914 * 12 =
7.7063%

Exhibit 4.

Constructing the Indifference Scenario (Note: This

question is interesting and its solution requires some real effort. I
want to see some real effort because it is a real world problem. :
Now that you have conducting analysis (2) and (3), I want you to
construct a financing strategy where PMFC will be indifferent between
deducting points upfront and financing points along with the loan. In
general the APR under the second alternative, i.e. financing points will
be different, depending on the shape of the yield curve. However,
there are circumstances under which the lender (PMFC) would be
indifferent between upfront discount points payment and financing
the discount points. That is PMFC will end up with the same APR
under either alternative. With this in mind construct a scenario and
work out an example by calculating the relevant APR on the loans to
show that indeed under certain circumstance PMFC will be indifferent
APR wise between the two alternatives of handling points. If this
scenario holds it will mean that PMFC will earn the same APR
regardless of whether the points were deducted upfront or rolled into
the loan amount. HINT: In solving this problem start by assuming that
the yield curve is flat, there are no arbitrage opportunities and also
ignore any transaction costs and taxes. A flat yield curve means
interest rate on short and long term instruments are essentially the
same.

Followed the calculations in Exhibit 1 and Exhibit 3.

Assumptions: Assume the yield curve is flat, there are no arbitrage opportunities
and there are no transaction costs and taxes.

Method 1: Combine with another investment to offset the difference

Followed the calculations in Exhibit 1 and Exhibit 3.
The real cash inflow/outflow for the lender are listed as below
T (by month)
Points deducted
upfront
Points along with
loan
Difference

Cash outflow at
T=0
-475,000
-500,000
-25,000

APR
7.7428
%
7.7063
%
X%

If we want to compensate the difference between two alternatives of handling

points indifferent

 475,000*7.7428%+25,000*X%=500,000*7.7063%
X = 7.0128%
The lender should use additional loan with face value of 25,000 and APR of
7.0128% to offset the differences.
Method 2: Combine with another investment to offset the difference
Followed the calculations in Exhibit 1 and Exhibit 3.
The real cash inflow/outflow for the lender are listed as below
T (by month)

T=0

PMT(T=1~T1
31)

Points deducted
upfront

475,00
0
500,00
0
25,000

3,533.89599

Points along with

loan
Difference

Loan due: PMT(T=132) +

mortgage value at the end of year
11
3,533.89599+377,794.9476=381,
328.8436

3,710.59100

3,710.591+396,684.695=400,395.
2860

176.69501

19,066.44240

If we want to compensate the difference between two alternatives of handling

points indifferent
PV=-25,000; PMT=176.69501; FV=19066.44240; N=132 CMPT =>
I=0.58725*12=7.05%
The lender should use additional loan with face value of 25,000 and APR of
7.05% to offset the differences.

Method 3: adjust face amount and discount points of the mortgage ???

Exhibit 6.
Computing the Book Value of the Balloon Mortgage one year after origination
Calculating the Debt Service
PV=-500,000, i=7/12, n=300, FV=0 CMPT Pmt=3533.895
Calculating the present value of annuity part of balloon mortgage
Pmt=3533.896, i=7/12, n=120,FV=0 CMPT PV= -304,361.58
Calculating the Balloon amount

Pmt=3533.896, i=7/12, n=168, FV=0 CMPT PV= -377,794.949

Discounting the balloon amount to get the present value at one year after
origination
FV=377,794.949, n=120, i=7/12, Pmt=0 CMPT PV = -187,989.36
Therefore total book value of loan at one year after origination is = 304,361.58 +
187,989.36 = 492,350.94
Now Computing the Market Value of the Balloon Mortgage one year after origination
Calculating the Debt Service
PV=-500,000, i=7/12, n=300, FV=0 CMPT Pmt=3533.895
Calculating the present value of annuity part of balloon mortgage
Pmt=3533.896, i=8.5/12, n=120, FV=0 CMPT PV= -285,024.51
Calculating the Balloon amount
Pmt=3533.896, i=7/12, n=168, FV=0 CMPT PV= -377,794.949
Discounting the balloon amount to get the present value at one year after
origination
FV=377,794.949, n=120, i=8.5/12, Pmt=0 CMPT PV = -161,959.75
Therefore total market value of loan at one year after origination is = 285,024.51 +
161,959.75 = 446,984.26
Finally the capital loss from sale of mortgages will be = 492,350.94-446,984.26=
45,366.68

Exhibit 7.
Forward contract for 4 mortgages worth 2 million @ 7% for 25 years in exchange for
2 million
Given, 75% closure fallout of 25%
So, the lender will deliver 75% of loan amount i.e. 1.5 million @ 7% for 25 years but
will have to buy the remaining amount of 500,000 in a market environment where
interest rate is declined to 6.5%
Calculating the debt service
PV= -500,000, i=7/12, n=300, FV=0 CMPT Pmt = 3533.896
Now computing the market value of the loan at market rate of 6.5%
Pmt= 3533.896, i=6.5/12, n=300, FV=0 CMPT PV= -523,379.52
Therefore, total loss incurred due to the forward contract with 25% fallout is =
523,379.52-500,000= 23,379.52
Now Incase PMFC uses put option instead of forward contract, it has right but no
obligation to deliver the loan. Thus, when interest rate decrease to 6.5%, the put
option in out of the money and thus only 1.5 million loan at 7% for 30 years is
delivered
Calculating the Debt Service in this case,
PV=1,500,000, i=7/12, n =300, FV=0 CMPT Pmt= 10,601.69
Now computing the market value of the loan at market rate of 6.5%
Pmt= 10,601.69, i=6.5/12, n=300, FV=0 CMPT PV= -1,570,138.55
Therefore, total gain incurred due to the put option with 25% fallout is =
1,570,138.55-1,500,000=70,138.55