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Unformatted text preview: and there are no other risks, what should you charge each type of borrower? Good Type: 8% (borrower accepts if Op Cost > 8%) Bad Type: 35% (borrower accepts if Op Cost > 35%) b) More Realistic: Can’t Distinguish Between Borrower Types (i) Charge Single Interest Rate to Pool of Borrowers (ii) Adverse Selection: Example 3 (cont’d). Now assume you can’t distinguish between borrower types and there is an equal percentage (50% of each) of good and bad types of borrowers. What interest rate will you charge everyone? What happens if all good types have an opportunity cost = 13% though? Percentage Expected to Default: Real Estate Finance Dr. Eriksen Practice Problem: What interest rate would you charge a pool of borr
rowers of that is 90% composed of good types that will pay you back next year and 10% of b orrowers that will pay you nothing? Assume you can’t distinguish between type of borrowers and yo u want to ear a default‐adjusted rate of rn
return equal to 8%? c) Most Realistic: Multi‐Period Model with Collater al (i) Loan Severity: (ii) Default Hazard Rate (h): Example 4. What is Your Yield on a $100,000 3‐year IO M ortgage Loan with 10% Annual Interest Rate and Payments if you assume a 25% Loss Severity and De fault Hazard Rate of 10%? Categories of Borrower Types 1. Borrower Never Makes a Payment 2. Borrower Defaults End of Period 2 3. Borrower Defaults End of Period 3 4. Borrower Never Defaults d) An Optimal “Interest” Rate Doesn’t Always Exist! t
(i) Adverse Selection: (ii) Good Borrowers Reaction: Real Estate Finance Dr. Eriksen E. What Do I Think $1 will buy Tomorrow? (Interest‐Rate or Unanticipated Inflation Risk) 1. Borrowers Will Pay You Back with Fiat...
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