Mortgage Payments and Equity Premium Puzzle

41 Pages Posted: 24 Jan 2021

See all articles by Tien Foo Sing

Tien Foo Sing

National University of Singapore (NUS) - Department of Real Estate

Yiheng Zou

National University of Singapore (NUS) - Department of Real Estate

Date Written: November 28, 2020

Abstract

The equity premium puzzle argues that equity risk alone is insufficient to justify observed equity premiums with a reasonable value of risk aversion. Mortgages account for a substantial part of household debt, it is thus necessary to take the mortgage payment obligations into consideration when addressing the puzzle. This paper examines how the mortgage payment obligations affect the stochastic discount factor in the pricing kernel and influence the equity premium. The proposed asset pricing model incorporating the mortgage payment factor explains the observed equity premium with an acceptable risk aversion value of $1.2$. Mortgage payments affect the utility function in two dimensions. First, the payments hurt individuals by decreasing their overall utility level. Second, the countercyclical effect of the payments benefits individuals by decreasing the volatility of the utility stream. This paper contributes to the literature by highlighting the importance of mortgages in predicting the equity premium.

Keywords: Equity Premium Puzzle, Mortgage Payments, Household Debt, Stochastic Discount Factor, Risk Aversion

JEL Classification: G12, G21, R30

Suggested Citation

Sing, Tien Foo and Zou, Yiheng, Mortgage Payments and Equity Premium Puzzle (November 28, 2020). Available at SSRN: https://ssrn.com/abstract=3739062 or http://dx.doi.org/10.2139/ssrn.3739062

Tien Foo Sing (Contact Author)

National University of Singapore (NUS) - Department of Real Estate ( email )

4 Architecture Drive
Singapore 117566
Singapore

Yiheng Zou

National University of Singapore (NUS) - Department of Real Estate ( email )

4 Architecture Drive
Singapore 117566
Singapore

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