In this selection, Admati and Hellwig illustrate the effect of leverage by calculating

Kate's ROE from borrowing money for one year to buy a $300,000 house. For different

rates of housing appreciation, they compare Kate's ROE under two alternative

assumptions about leverage?a $30,000 down payment (high leverage) and a $60,000

down payment (low leverage). Assume (in contrast to real-life mortgages) that the loan

is a one-year loan with both principal and interest due at the end of the year.

Question 1

: In the first worksheet in the Excel spreadsheet, reproduce Table 8.1 on p.

118 by filling in columns D and columns F to I. After completing the table, plot two

curves in your spreadsheet relating ROE to the year-end house price?one for a down

payment of $30,000 and the other for a down payment of $60,000, and both in the same

chart. (Hint: Use the scatter plot option with connected lines.) Which curve is steeper?

Question 2.

From this example, what can you conclude about the conditions under which

an increase in leverage will increase ROE? Explain, referring to your results. (Hint:

where do the two curves cross? Why do they cross there?)

Question 3.

From this example, what can you conclude about the effect of leverage on

the riskiness of ROE and the probability of insolvency? Explain, referring to your

results.

A B C D E F G H Cost of house Borrowing rate Down payment Amt. owed EOY house price Final equityl ROE1 (%) Final equity2 ROE2 (%) 300,000 0,04 30,000 345,000 60,000 340,000 335,000 330,000 325,000 320,000 315,000 312,000 310,000 305,000 300,000 295,000 290,000 285,000 280,800 280,000 275,000 270,000 265,000 260,000 255,000 250,000 249,600 245,000