Due to the COVID crisis, UNM is negotiating a contract to borrow $300,000 to be repaid in a lump sum at the end of nine years. Interest payments will be made on the loan at the end of each year. UNM is considering the following three financing arrangements:

Option 1: UNM can borrow the money using a fixed-rate loan (FRL) that requires interest payments of 9% per year.

Option 2: UNM can borrow the money using an adjustable-rate loan (ARL) that requires an interest payment of 6% at the end of each of the first five years. At the beginning of the sixth year, the interest rate on the loan could change to 7%, 9%, or 11% with probabilities of 0.1, 0.25, and 0.65 respectively.

Option 3: UNM can borrow the money using an ARL that requires an interest payment of 4% at the end of each of the first three years. At the beginning of the fourth year, the interest rate on the loan could change to 6%, 8%, or 20% with probabilities of 0.05, 0.30, and 0.65, respectively. At the beginning of the seventh year, the interest rate could decrease by 1 percentage point with a probability of 0.1, increase by 1 percentage point with a probability of 0.2, or increase by 3 percentage points with a probability of 0.7.

Create a decision tree for this problem, computing the total interest paid under each possible scenario. Do nothing is not an option in this problem. UNM has to borrow money.

Question 9

What is the payoff at the terminal node if UNM chooses Option 3 and the interest rate change to 6% at the beginning of the fourth year and decrease by 1% at the beginning of the seventh year?

A. -135,000

B. -174,000

C. -198,000

D. -222,000

Question 10

Which option should UNM choose to minimize the expected interest paid?

A. Option 1

B. Option 2

C. Option 3