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Bias in an Empirical Approach to Determining Bond and Mortgage Risk Premiums

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  • Childs, Paul D
  • Ott, Steven H
  • Riddiough, Timothy J

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 effect of various other sources of risk, however, including collateral asset market risk, interest rate risk, and possibly call risk. These omissions downwardly bias 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 noncallable or subject to a temporary prepayment lockout 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. Copyright 1997 by Kluwer Academic Publishers

Suggested Citation

  • Childs, Paul D & Ott, Steven H & Riddiough, Timothy J, 1997. "Bias in an Empirical Approach to Determining Bond and Mortgage Risk Premiums," The Journal of Real Estate Finance and Economics, Springer, vol. 14(3), pages 263-282, May.
    • Handle: RePEc:kap:jrefec:v:14:y:1997:i:3:p:263-82
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    Cited by:

    1. Shu Ling Chiang & Ming Shann Tsai & Shan Jiang, 2021. "The Influences of Foreclosure Factors on the Value, Yield, Duration and Convexity of a Mortgage," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 49(S2), pages 361-394, September.
    2. Tsai, Ming-Shann & Liao, Szu-Lang & Chiang, Shu-Ling, 2009. "Analyzing yield, duration and convexity of mortgage loans under prepayment and default risks," Journal of Housing Economics, Elsevier, vol. 18(2), pages 92-103, June.
    3. Xudong An & Yongheng Deng & Joseph Nichols & Anthony Sanders, 2013. "Local Traits and Securitized Commercial Mortgage Default," The Journal of Real Estate Finance and Economics, Springer, vol. 47(4), pages 787-813, November.
    4. Armonat, Stefan & Pfnür, Andreas, 2002. "Basel II and the German credit crunch?," Publications of Darmstadt Technical University, Institute for Business Studies (BWL) 35585, Darmstadt Technical University, Department of Business Administration, Economics and Law, Institute for Business Studies (BWL).

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