Question

5. In what ways is a mortgage lender who makes a real estate mortgage loan similar to selling a put option? Also, in what ways is making a real estate mortgage loan similar to selling a call option?

Answer 1

How mortgage lending is similar to selling a Put option

When you sell a put option the profit is limited to the small amount of premium received & loss can be very high and starts increasing as the price of the underlying asset falls below break even point ( strike price + premium). for eg suppose stock abc is at 100 and the put option at 100 is sold at 5 . the profit of put seller will be limited to 5 but the loss cn be very high and start increasing as price of the underlying asset goes below the breakeven point of 95 (100-5) . suppose the price falls to 50 then the loss to option seller will be 95-50 = 45.

Similary when a person buys a real estate on mortgage he is basically buying an put option and the mortgage lender is selling the put option and the downpayment made by the buyer can be related to the premium paid for the put option. For eg , suppose a real estate of 100000 has a downpayment of 10000 and the price of real estate falls to 50000 . in this case the mortagage buyer is assumed to be a put buyer and mortgage lender is the put seller, downpayment of 10000 is the premium which the mortgage lender is receiving. in case the mortgage buyer decides to default and walk away the mortgage lender will have a loss of 50000-10000 = 40000 (50000 loss on property value - 10000 downpayment received)

How mortgage lending is similar to selling a Call option

When you sell a call option the profit is limited to the small amount of premium received & loss can be very high and starts increasing as the price of the underlying asset increases above  break even point ( strike price + premium). the option seller basically gives up on the gain if the underlying asset appreciates in exchange for the premium. for eg suppose stock abc is at 100 and the call option at 100 is sold at 5 . the profit of call seller will be limited to 5 but the loss cn be very high and start increasing as price of the underlying asset goes above the breakeven point of 105 (100+5) . suppose the price incrreases to 150 then the loss to call option seller will be 150-105 = 45

Similary when a person buys a real estate on mortgage he is basically buying an call option and the mortgage lender is selling the call option and the downpayment made by the buyer can be related to the premium paid for the call option. For eg , suppose a real estate of 100000 has a downpayment of 10000 and the price goes up to 150000 . in this case the mortagage buyer is assumed to be a call buyer and the mortgage lender is assumed to me the call seller, downpayment of 10000 is the premium which the mortgage lender is receiving. The mortgage buyer call sell the real estate at 150000 and keep the profits and the mortgage lender has basically given up the gains in exchange of downpayment received.