Economics

The Equity Risk Premium

To understand the advantage of the Index Mortgage it is useful to first understand the Equity Risk Premium.

Equities are riskier investments than government bonds.  Correspondingly, in order to invest in equities investors demand a spread or premium over the so-called Risk Free Rate.  This is the Equity Risk Premium.  In the developed world, the Equity Risk Premium typically ranges between 3 and 9 percent per annum – as to which click here.

The Excess Risk Premium

Whilst the Equity Risk Premium is “forward looking” (and so is an estimate), one approach to its computation is to extrapolate the historical difference between the return offered by equities and the Risk Free Rate.  By way of example, over the period from 1900 to 2014, the average difference between the annualised return of the All Ordinaries index and bank accepted bill yields was 6.6% per annum.  Sources:- Dimson, Marsh and Staunton: Global Investment Returns Database (2015); Bianchi, Drew and Walk: The (un)Predictable Equity Risk Premium (2015)

Such a differential is typically greater than the margin paid by a prime mortgage borrower.  Hence, we observed that, over the medium to long term, there was a high probability of a positive difference between Total Return and Prime Borrower Home Lending Rates.  We call that difference the Excess Risk Premium.  For our paper on the effect of accumulating the Excess Risk Premium, click here to download a PDF.

We developed a mechanism to efficiently accumulate the Excess Risk Premium and apply it to the benefit of the mortgage borrower, through a reduced mortgage interest rate.  The result is the Index Mortgage.

Other Asset Classes & Strategies

Of course, investment strategies other than “long equities” can also outperform Prime Borrower Home Lending Rates.  Generally speaking, any asset class or investment strategy can be made the subject of an Index Mortgage.

“The Index Mortgage is unique. It provides the raw materials for the development of a whole new generation of financial products.”

Citigate Dewe Rogerson, LaunchSure Report