Bias in Empirical Approach to Determining Bond and Mortgage Risk Premiums

J. OF REAL ESTATE FINANCE AND ECONOMICS, Vol. 14 No. 3

Posted: 14 Mar 1997

See all articles by Paul D. Childs

Paul D. Childs

University of Kentucky

Steven H. Ott

University of North Carolina (UNC) at Charlotte - Department of Finance & Business Law

Timothy J. Riddiough

University of Wisconsin - School of Business - Department of Real Estate and Urban Land Economics

Abstract

Empirical studies of bond and commercial mortgage performance often quantify a required risk premium by examining the difference between the promised yield and the realized yield as adjusted for default occurrence. These studies omit the effects of various other sources of risk, however, including collateral asset market risk, interest rate risk and possibly call risk. This omission downwardly biases the empirical risk premium estimate on the debt. In this paper we disentangle and quantify the sources of this bias by modeling secured coupon debt (the commercial mortgage) as used in the calculation of a realized investment return. We consider deterministic and stochastic interest rate economies with mortgage contracts that are either non-callable or subject to a temporary prepayment lock-out period. Given realistic parameter values associated with the term structure, underlying asset dynamics and debt contracting, we show that the magnitude of the bias can be significant.

JEL Classification: R19

Suggested Citation

Childs, Paul David and Ott, Steven H. and Riddiough, Timothy J., Bias in Empirical Approach to Determining Bond and Mortgage Risk Premiums. J. OF REAL ESTATE FINANCE AND ECONOMICS, Vol. 14 No. 3, Available at SSRN: https://ssrn.com/abstract=9236

Paul David Childs

University of Kentucky ( email )

College of Business & Economics
Lexington, KY 40506-0034
United States
606-257-2490 (Phone)
606-257-9688 (Fax)

Steven H. Ott

University of North Carolina (UNC) at Charlotte - Department of Finance & Business Law ( email )

9201 University City Blvd.
Charlotte, NC 28223
United States
704-687-2744 (Phone)
704-687-6987 (Fax)

Timothy J. Riddiough (Contact Author)

University of Wisconsin - School of Business - Department of Real Estate and Urban Land Economics ( email )

School of Business
975 University Avenue
Madison, WI 53706
United States
608-262-3531 (Phone)
608-265-2738 (Fax)

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