Question

1. Explain the term structure of interest rates and the relationship measured. Why must all securities plotted on a given term structure have equal default risk? Of the 4 theories ex- plaining the shape of the yield curve which do you think is most plausible or useful? Why? 2. What is included in the closing costs of a mortgage loan? What counts as income for the bank? What is the purpose of escrow?

Answer 1

1) Term structure of interest rates, commonly known as the yield curve, depicts the interest rates of similar quality bonds at different maturities.

A yield curve tells us about the relative cost of short-term and long-term debt and allows companies to not only decide about the structure and timing of their capital structure changes, but it also carries important information about the economic outlook and financial market conditions. In order to have a common ground of comparison considering all the above factors it is required that all securities have equal default risk.

In my view market-segmentation theory is most plausible because it supports the notion that separate demand and supply determinants exists for short-term and long-term securities and their interplay in distinct markets determine the shape of the yield curve. Since every market player is constrained by his own requirements, he had demand for or supply of instruments of specific maturity. If the demand for long-term capital is higher than its supply, the long-term rate will be higher and so on.

2) Closing costs are the expenses, over and above the price of the property, that buyers and sellers normally incur to complete a real estate transaction.

Costs incurred may include loan origination fees, discount points, appraisal fees, title searches, title insurance, surveys, taxes, deed-recording fees and credit report charges. Prepaid costs are those that recur over time, such as property taxes and homeowners' insurance.

The mortage charges would be considered income for the bank.

Escrow is a process used when two parties are in the process of completing a transaction, and there is uncertainty over whether one party or another will be able to fulfill their obligations.