Question: You work for an investment company that is considering the purchase of a ‘‘seasoned'' mortgage loan that was originated two years ago. The original principal amount of the loan was $2,000,000, and it has an interest rate of 8%, a 15-year term and amortization period, monthly payments, and no prepayment penalty. You decide to value the loan based on the assumption that the loan is held to full maturity (i.e., there is no prepayment). Since interest rates have fallen somewhat in the past year, you offer a price based upon a required return or yield to maturity of 7.25%.

a. What price do you offer for the loan package (i.e., under your assumptions, what is the current market value of the loan)? Compare this to the current OLB or ‘‘book value'' of the loan, and explain the difference.

b. Assume you purchase the loan at the price you determined in part (a) and that interest rates continue to fall afterwards, and as a result, the borrower prepays the mortgage 14 months from today. What yield or IRR will you have realized?

c. Consider the situation in part (b). Determine the size of the prepayment penalty ($ amount) that would have ensured that you earned a yield (or IRR) of 7.25%.