Mortgage Payments and Equity Premium Puzzle
41 Pages Posted: 24 Jan 2021
Date Written: November 28, 2020
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: Suggested Citation