6) Suppose a family member approaches y to borrow s2.000 for the down payment on

Question

6) Suppose a family member approaches y to borrow s2.000 for the down payment on an automobile. You have the cash available in a savings account that earns 5% annual interest. You and the currently family member consider the following repayment options: (i Borrower repays $259 each year over the next ten years. (ii) Borrower repays $300 each year over the next five years, plus a lump-sum payment of $895 in the fifth year. (iii) Borrower repays you $2.100 at the end of one year. For each of the options above, show that the present values of each option are approximately equal. Then, relate each of the options above to the four types of bonds, indicating which option is equivalent to which type of bond. Explain why. 7) Suppose that the interest rate on a conventional 30-year mortgage is currently 8%. You receive a call from a mortgage broker who offers you a 30-year adjustable rate mortgage at 2% that is adjusted once each year. Evaluate each mortgage in terms of the f risk that the monthly payment will change over the next 30 years and interest-rate risk.

Explanation / Answer

Option 1-

$2000 in savings account,PV= $2000

Option 2-

$259 every year for 10 years-

$259*PVAF(5%,10 years)

$259 * 7.72

$1999.93

Option 3-

$300 for five year and $ 895 in fifth year

$300*PVAF(5%,5years)+$895*PVF(5th year 5%)

$ 300 * 4.3294+ $ 895*.7835

$1999.9

Option 4-

$2100 at the end of 1 year

$2100*PVF (1yr 5%)

$2100*.9523

=1999.99

Thus it is approximately the same.

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