Explain the difference between an index and spread (or margin). 2. List each of the main terms likely to be negotiated in an ARM. What does pricing an ARM using these terms mean? 3. What is the difference between interest rate risk and default risk? How do combinations of terms in ARMs affect the allocation of risk between borrowers and lenders? Problems 

1. A basic Adjustable Rate Mortgage (ARM) loan is made for $280,000 at an initial interest rate of 6.5 %for 30 years with an annual reset date. The borrower believes that the interest rate at the beginning of year (BOY) 2 will increase to 7.25%. a. Assuming that a fully amortizing loan is made, what will the monthly payments be during year 1? b. Based on (a) what will the loan balance be at the end of year (EOY) 1? c. Given that the interest rate is expected to be 7.25% at the beginning of year 2, what will the monthly payments be during year 2? d. What will be the loan balance at the EOY 2? e. What would be the monthly payments in year 1 if they are to be interest only?