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

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

Research output: Contribution to journalArticlepeer-review

9 Scopus citations

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. 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.

Original languageEnglish
Pages (from-to)263-282
Number of pages20
JournalJournal of Real Estate Finance and Economics
Volume14
Issue number3
DOIs
StatePublished - 1997

Keywords

  • Debt valuation
  • Default risk
  • Mortgage default
  • Option pricing

ASJC Scopus subject areas

  • Accounting
  • Finance
  • Economics and Econometrics
  • Urban Studies

Fingerprint

Dive into the research topics of 'Bias in an Empirical Approach to Determining Bond and Mortgage Risk Premiums'. Together they form a unique fingerprint.

Cite this