Mortgage payments and equity premium puzzle

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 consider the mortgage payment obligations 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 counter-cyclical 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.