Hi, need a quick clarification here.
Reading 45, page 35, the book states that: " Each monthly mortgage payment for this mortgage design is due on the first of each month", indicating a due annuity. However, in Exhibit 1, the payment calculated (742.50) is that of an immediate one. Could anyone help about this? Do they mean the first of each month, starting next month?
Annuity due is calculated at the beginning of each period, starting today. No different than a capital lease. It’ll help if you think in terms of a real loan on your house - you make the payments on the first of every month, with the first payment due on the day you sign the loan. Pretty much all mortgages in the US are designed this way.
Thanks Aether. But then, like I said, the example in Exhibit 1 gives the payment of an immediate annuity? Why is it so?
Immediate Annuity = Annuity Due. Not sure what’s unclear?
http://en.wikipedia.org/wiki/Annuity_(finance_theory)
annuity immediate = payment at the end of the month
annuity due = payment at the beginning of the month
in other words, the 742.50 is solved using end of period CF
if you switch your BAII to BGN mode (annuity due), you’d get 600 something
just want to understand why those 2 contradict each other…
I usually don’t like to depend on “sources” like Wikipedia for clarifying CFAI core material.
Here are the definitions CFAI uses for annuities at L1:
“An ordinary annuity has a first cash flow that occurs one period from now (indexed at t = 1).” “An annuity due has a first cash flow that occurs immediately (indexed at t = 0).” There’s no notion of an “immediate annuity” like Wikipedia tends to claim. There’s clearly a difference between what you found and what the CFAI’s talking about. I tend to think in terms of time = 0 = immediate (just like CFAI L1 material says). Edit: Looking at your original post, it’s clear that Wikipedia is your source of confusion :).
Well, I can clarify (from other material that I studied) that the definitions on Wiki are correct, and that the term “annuity immediate” does exist, and that it is essentially the same as “ordinary annuity” as used by CFAI. In fact, the Wiki page does say “the annuity is called an annuity-immediate, or ordinary annuity.”
I know, the term may be misleading, because it’s “immediate” but the payment starts one period from now, but “immediate” here is to distinguish between this type of annuity and deferred annuity, where the payments don’t start immediately but deferred until several periods later.
Anyway, terms aside, my question is: why in the reading, they say that the mortgage payment is designed to be on the first of each month; but then in the example, they calculate the payment as if it is paid at the end of the month? (Hope I rephrase the question better this time…)
As I mentioned in my original post - this is how US mortgages are structured… there’s no rhyme or reason to it. It’s simply a convention. Use “ordinary annuity” calculations and apply them to the mortgage immediately. My first post probably seemed like I was saying a mortgage is like an annuity due - that wasn’t the intention. I was simply trying to point out what annuity due/immediate was structured like, and how the concept is used in representing mortgages.
As far as terms go - there’s a lot in the CFAI material that may refute the outside world. It’s best to ignore everything outside the curriculum (at least with regards to the exam). This is no different than the CFAI using its own convention for FX than the rest of the market. Majority of the FX quotations are listed as base/price. However, CFAI uses the price/base convention because it’s easier to explain mathematical derivations. Just my two cents on subject… if you can handle differences between the CFAI material and the outside world, more power to you :).
Use your BAII calculator for this, and make sure you set payments to END , also don’t forget to set P/Y to 12, for 12 pay periods 1 per month, finally when looking at Prin and int pymts for a period make sure P1 and P2 both show the same period. For example if I want to know this info for the 10th month then P1 = 10 and P2=10. Presonally I like to understand what im doing but sometimes you just need to memorize it