A company is faced with a 20 percent chance of a weak economy, a 40 percent chance of an average economy, and a 40 percent chance of an above-average economy. The company would expect only a 10 percent return in a weak economy, an 18 percent return in an average economy, and a 30 percent return in an above-average economy.
Weight of each economic condition
W P = 20/(20+40+40) = 20/100 =0.2
W A = 40/(20+40+40) = 40/100 = 0.4
W AA = 40/(20+40+40) = 40/100 = 0.4
Using E(r i ) as the expected return for the company, the weights are used to calculate the returns
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E(r i ) = (W P ) X E(r p ) + (W A ) X E(r A ) + (W AA ) X E(r AA )
= 0.2 *10 +0.4*18 + 0.4* 30
=2+7.2+12
=21.2%
(Gibson et al., 2013).
| Economy | Return R i | E(r i ) | R i - E(r i ) | (R i - E(r i )) 2 | W i (R i - E(r i )) 2 |
| Poor |
20 |
21.2 |
-1.2 |
1.44 |
0.144 |
| Average |
40 |
21.2 |
18.8 |
353.44 |
141.376 |
| Above Avg |
40 |
21.2 |
18.8 |
353.44 |
141.376 |
|
Sum |
282.896 |
||||
Standard deviation = ⱱ282.896
= 16.82
The standard deviation or volatility measures the variability of expected returns of the scenario. There are two components of return, i.e., the expected return and the standard deviation. The expected return demonstrates on an average the return that the company expects to get in the three scenarios. It shows the consistency in which the returns are to be generated with larger values indicating high risks. Standard deviations are consistent in their computation and what they represent (Gibson et al., 2013).
Scenario two
| Existing mortgage | Refinancing | |
| Balance | $100,000 | $100,000 |
| Remaining years | 14 | 15 |
| Interest rates | 7 | 5.5 |
| Monthly payments | $935.40 | $817.08 |
| Closing costs | $2000 | $1500 |
| Savings | $118.32 per month $1419.84 per annum | |
From the above table, the total savings for the mortgage period will be $1419.84 X 14 = $19,877.76. In addition to the savings, the payer will also have less closing cost in the new arrangement compared to the current agreement. Therefore, there is also an increase in the savings to $20,377.76. From the computations, the payer should refinance the mortgage to take advantage of the reduced interest rates. In deciding to refinance the mortgage, some of the considerations that should be made include the effort and time required for refinancing. Time is necessary to compare and apply for mortgage refinancing. The home has to be appraised, and various documents will be required by the lender. Similarly, the duration in which one desires to live in the house will determine whether to refinance or not. The out of pocket closing costs can be high in the initial stages and therefore if one intends to move soon, they might not benefit from the low-interest rates. If a refinance is done and the home is sold, the owner will lose money because it takes time to recoup the upfront costs paid in the process. The closing costs should also be considered in the refinancing. Such costs can significantly impact the overall cost of the mortgage both in the short run and over the lifetime of the mortgage. A mortgage can be refinanced for some reasons including improved credit rating or score, the credit profile, changes in the interest rates, desire for a fixed rate mortgage, when a consignor has to be removed and when the borrower wants to borrow against the mortgage (Parameswaran, 2011).
References
Gibson, R., Michayluk, D., & Van de Venter, G. (2013). Financial risk tolerance: An analysis of unexplored factors. Financial Services Review, 22(1), 23–50.
Parameswaran, S. (2011). Fundamentals of financial instruments: Stocks, bonds, foreign exchange, and derivatives. Hoboken, NJ: John Wiley & Sons
