In this selection, Blinder assumes that John and Jane take out a mortgage with a 20%

down payment to invest in a $200,000 house that they expect to appreciate 20% over five

years. In calculating their ROE over the period, Blinder ignores the interest they have to

pay on the mortgage, which is like treating the borrowing rate as zero.

Question 1

. In the second worksheet in the Excel spreadsheet, show what John and

Jane's ROE would be under three different assumptions about the borrowing rate: a) a

rate of zero, as effectively assumed by Blinder; b) a rate of 10%; and c) a rate of 20%, the

same as the housing inflation rate. (To make things simple, assume that these are one-

year rates and that the length of the period is one year instead of five years.) This

requires you to fill in columns E to G in the worksheet.

Question 2

. Blinder uses this example to argue that the opportunity to make big profits

from leverage contributed to the housing bubble. Based on your answer to Question 1,

does the example support his argument? Explain. (Hint: If the borrowing rate equals the

rate of housing inflation, would John and Jane do better taking out the mortgage than

paying for the house entirely with their own money?)

Answer:

Question 3:

Answer Question 1 assuming that John and Jane make a down payment of

$20,000 instead of $40,000 (i.e., higher leverage).

This requires you to fill in columns I

to K in the worksheet.

Question 4:

Based on your answer to Questions 1-3, is the relationship between leverage

and ROE the same as in Part 1 of this assignment, once we take into account the

borrowing rate? Explain.

Answer:

A C D E F G H K Cost of house EOY house price Down paymentl Borrowing rate Amt. owed1 Final equity1 ROEL [) Down payment2 Amt. owed2 Final equityz ROE2 [*) 200,000 240,000 40.000 0.00 201000 0.10 0.20