Derivative Investment Essay Example | Topics and Well Written Essays - 2750 words

Derivative Investment - Essay Example The other option available is to default the payment on the mortgage. It may be noted that both of these options are available with the borrower. In this context this paper presents a report on the features of the mortgage in general and an analytical study of the implicit options contained in them through an illustration. A mortgage bond issue is secured by a lien on the specific assets of an individual or a business corporation - usually fixed assets. The specific property securing the bonds is described in detail in the mortgage which is the legal document, giving the bondholder a lien on the property. As with other secured lending arrangements the market value of the collateral should exceed the amount of the amount lent or the amount of bond issue by a reasonable margin of safety. If the corporation or the individual defaults in any of the provisions of the bond indenture the lender or the trustee on behalf of the bondholders, has the power to foreclose. In a foreclosure the lender or the trustee takes over the property and sells it using the proceeds to pay the amount of debt due to the lender. If the proceeds are less than the amount of bond issue or the loan amount outstanding the bondholders or the creditor become an unsecured creditor for the balance amount. A company may have more than one bond issue secured by the same property. If a bond issue is secured by a second mortgage and the first mortgagee forecloses the first mortgage bond-holders must be paid the full amount owed them before there can be any distribution to the second mortgage bondholders (James C. Van Horne) 3.0 Kinds of Mortgages There are basically two kinds of mortgage loans; fixed rate mortgages and adjustable rate mortgages. 3.1 Fixed Rate Mortgages Fixed rate mortgages represent a very stable and popular type of mortgage. In a fixed rate mortgage the rate of interest is fixed for the life of the loan. The repayments are equal and occur at regular intervals. Normally the repayment is fixed on a monthly basis. The monthly payments constitute the payment of interest on the remaining balance and the repayment of a part of the principal amount. The mortgage term extends normally from 15 to 30 years. The fixed mortgage can be prepaid at any point of time at the discretion of the borrower. The risk on the interest rates and the prepayment risks are taken into the account of the lender. Fixed rate mortgages carry several definite advantages. The chief advantage is that in fixed rate mortgage the interest and the repayment are protected from inflation. Irrespective of the increases in the interest rates caused by any inflation the principal and interest remain same in the fixed rate mortgage. It also helps in the financial planning of t he individuals. The fixed rate mortgages are generally considered as low risk loans as the interest rate is not affected by the changes due to inflation. 3.2 Adjustable Rate Mortgages (ARM) According to the Federal Reserve Board the adjustable rate mortgages are loans that possess the interest rate that changes periodically or according to the loan covenants. There may be instances where the ARMs may start with lower monthly payments than fixed rate mortgages but may increase over a period of time depending upon the terms of the mortgage. For the same amount of loan the ARM