Required Risk Premium Research Articles

Uses of Equilibrium Models in Real Estate Research

Equilibrium analysis is a valuable tool in real estate investment research. In this survey, I show how equilibrium models have been used to estimate the required risk premium for different classes of real estate, to explain housing prices and rents, and to determine investment rental market adjustment and valuation (as well as to predict future rent, price and value developments). Equilibrium analysis, combined with option theory, has also increased our understanding of differences in coupon/rental rates on loans/leases with different contract provisions (or our understanding of differences in values of contracts with different provisions but the same coupon/rental rates). Because the work on leases has lagged that on loans or mortgages, application of the mortgage research methodology to leases is an especially fertile area for research.

Bias in Empirical Approach to Determining Bond and Mortgage Risk Premiums

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.

Uses of equilibrium models in real estate research

Equilibrium analysis is a valuable tool in real estate investment research. In this survey, I show how equilibrium models have been used to estimate the required risk premium for different classes of real estate, to explain real house prices, and to determine investment rental market adjustment and valuation (as well as to predict future rent, price and value developments). Equilibrium analysis has also increased our understanding of differences in coupon/rental rates on loans/leases with and without various option like features. Because the work on leases has lagged behind that on loans or mortgages, application of the mortgage research methodology to lease is an especially fertile area for research.

Financing Internal Buyouts of Private Companies: SCIN Attractive If Valuation Issues Can Be Resolved

In planning for succession of ownership, oftentimes the owner of a private business seeks to sell the business to either family members or employees. Arranging outside financing may be difficult or costly, making internal financing attractive. Self-cancelling installment notes (SCINs) provide an opportunity to finance the transfer of ownership at a favorable interest rate and to obtain income and estate tax advantages. However, to pass muster with the Internal Revenue Service, the SCIN must include a risk premium for the cancellation feature. In this paper, we provide a mathematical model for computation of the required risk premium associated with the cancellation provision. The premium may be in the form of either an interest premium or a principal premium and the computations for both are demonstrated in this paper. Appendix A provides an example of the use of the formulas.

A Model of the Underwriting Cycle in the Property/Liability Insurance Industry

A number of researchers have noted the existence of a cycle with a period of approximately six years in the profits of the property-liability insurance industry (Cummins and Outreville [2], Doherty and Kang [3], Simmons and Cross [5], Smith and Gahin [6], Venezian [8]). Although it has been recognized that a second order autoregressive equation will generate a six year cycle under some parameterizations, there has not been a satisfying theoretical derivation of such a relationship. The usual explanation (Stewart [7], Wilson [9]) for the existence of the cycle is that profits increase surplus (capacity), leading to aggressive marketing (i.e., more liberal underwriting standards) and declining profitability, which leads to a decline in surplus followed by increased profitability. The purpose of this paper is to develop a formal model, consistent with this explanation, which yields a second order difference equation in profits. A simple specification is provided which generates a six year cycle in profitability. Although this explanation has often been described as a cobweb model, the dynamics do not rest on supply being incorrectly based on last period's price. Rather, the key feature is that profits feed back into surplus, leading to an offsetting shift in supply due to a change in the required risk premium. Several competing hypotheses have recently been put forward to explain the cycle (see Cummins and Outreville [2] for a review). Ideally, however, noting the term underwriting cycle, the reported changes in underwriting standards over the course of the cycle need to be explained. In addition, the long history associated with the cycle argues for an explanation which points to the very basic economic fundamentals of the industry. Thus, the model developed herein excludes any consideration of expenses, taxes, investment income, interaction with the capital market, or ratemaking methodology; rather, the hypothesis is that the dynamics of the cycle derive from the fact that profits

Efficient Asset Portfolios and the Theory of Normal Backwardation: A Comment

In a recent paper, Carter, Rausser, and Schmitz (1983) (hereafter CRS) argue that previous studies of the risk premium on agricultural commodity futures contracts used incorrect proxies for the market index and consequently mismeasured the equilibrium risk premium on those contracts. CRS show that when an alternative market index is used to measure systematic risk, the required risk premium is positive and of economically significant magnitude. This result contradicts that of Dusak (1973) and supports the notion of a generalized Keynesian theory of normal backwardation. The purpose of this Comment is to argue that the market index constructed by CRS is inappropriate and that their empirical results stem directly from the use of this index.

Some factors determining municipal revenue bond interest costs

This paper tests for variations in risk premiums on municipal revenue bonds that are related to the geographic location of the issuer, the issue's second rating, and secondary collateral provisions. The empirical findings indicate that investors required risk premiums that depended on local economic conditions. Issuer borrowing costs were also shown to be related to factors that cause or reinforce segmentation of the tax-exempt bond market.