Full Answer Section

1. Prepayment Risk:
   • When interest rates fall, homeowners are more likely to refinance their mortgages at lower rates. This leads to early repayment of principal, reducing the mortgage bank’s expected future interest income.  
   • This risk is problematic because mortgage banks often fund long-term mortgages with short-term debt. When rates fall, they must reinvest the repaid principal at lower rates, impacting profitability.  
2. Discounting Effects:
   • The value of mortgage-related assets (mortgage-backed securities, loans) is sensitive to changes in interest rates. When rates rise, the present value of these assets decreases.  
   • This is because the fixed interest payments from the mortgages become less attractive compared to newly issued bonds with higher yields.
   • Mortgage banks holding these assets experience losses as the market value of their holdings declines.

Q.3: Determinants of Credit Risk Premium or Fee

The required credit risk premium or fee depends on four determinants:

1. Probability of Default:
   • The higher the perceived likelihood that the borrower will default on their obligations, the greater the required premium or fee. This reflects the increased risk of loss for the lender.
2. Loss Given Default (LGD):
   • This is the amount of loss the lender will incur if the borrower defaults. A higher LGD increases the required premium or fee. Factors influencing LGD include the value of collateral and the seniority of the debt.
3. Exposure at Default (EAD):
   • This is the total amount owed by the borrower at the time of default. A larger EAD leads to a greater potential loss, increasing the required premium or fee.
4. Correlation of Default:
   • If defaults are highly correlated (e.g., during a recession), the risk to the lender increases. This is because multiple borrowers are likely to default simultaneously, leading to larger losses. The higher the correlation, the greater the required premium or fee.

Q.4: Arguments Against Fair Value Accounting

Arguments against fair value accounting for financial instruments include:

1. Volatility and Earnings Distortion:
   • Fair value accounting can lead to significant volatility in reported earnings and equity, especially for instruments with actively traded markets. This volatility may not reflect the underlying economic performance of the company and can make it difficult for users to assess long-term profitability.  
2. Subjectivity and Measurement Uncertainty:
   • Determining fair values for illiquid or complex financial instruments can be subjective and involve significant estimation. This can lead to inconsistencies and potential manipulation of financial reports.
3. Procyclicality:
   • Fair value accounting can exacerbate economic cycles. During economic downturns, asset values may decline, leading to losses that force companies to sell assets, further depressing prices. This can create a downward spiral.
4. Lack of Relevance in Certain Cases:
   • For financial instruments held to maturity, fair value changes may not be relevant to the company’s long-term cash flows. Amortized cost accounting, which focuses on the actual cash flows, may be more relevant in these situations.
5. Cost and Complexity:
   • Determining fair values can be costly and complex, especially for companies with large portfolios of financial instruments. This can place a significant burden on companies and increase audit fees.
6. Availability of reliable inputs:
   • During times of economic crisis, the inputs needed to determine fair value may not be available, or may be unreliable, leading to inaccurate valuations