A real estate investor has bought an office building valued at $100 million. After a 10% down payment for the property price, the investor has borrowed a one-year mortgage loan at 10% interest rate from Nopay Bank to finance the remaining purchase price. The credit rating of the investor is ABB indicating that his probability of default is 3%. The current market value of the office building is $100 million. The office building is pledged with Nopay Bank as collateral. The market value of the office building at th end of one year is expected to be either up 30% or down 30%. The risk-free rate of interest to Nopay Bank is 4%.

Questions

a) Describe the payoffs to the real estate investor.

b) Describe the payoffs to the bank.

c) If Nopay Bank requires the investor to buy default insurance, how much would the insurance cost?

d) What is the default insurance cost if the down payment is 20% instead?

e) What is the default insurance cost if the volatility of the office price is expected to be 50% instead?