Question

it is very important that you show your work from the calculations (right down what you used as PV, i FV, n, cash flows,.....etc. in your calculation)

a. Given the following information, which ARM should have the lowest initial interest rate? ARMI ARM2 ARM3 % Margin above index 3% 2% 3% Adjustment Interval 6 months 1 year lyear Interest Rate Cap None 1% per year None (The three ARMs are identical in all other aspects) Briefly explain your answer! (2points)

Answer 1

ARM2 will have the lowest initial rate. This is so because it has a margin of 2% and an interest rate cap of 1%. Other two ARMs have a margin of 3% and no interest cap which means that they can reset to the highest rate, at the first reset only.

Next interest rate is lower of (index rate + margin) or (current rate + cap)

As can be seen, given that all three ARMs use the same index, ARM has the lowest margin and it is the only ARM with a cap, so it will have the lowest initial interest rate.