Academic journal article Journal of Risk and Insurance

The Effects of Macroeconomic Factors on Pricing Mortgage Insurance Contracts

Academic journal article Journal of Risk and Insurance

The Effects of Macroeconomic Factors on Pricing Mortgage Insurance Contracts

Article excerpt

ABSTRACT

Numerous empirical studies, including Abraham and Hendershott (1996), Muellbauer and Murphy (1997), Leung (2004), and Oikarinen (2009), have identified a significant relationship between housing prices and macroeconomic factors. Using a linear regression on the comovement of macroeconomic factors and housing prices, this article employs an option-pricing framework to price and hedge the fair premia of mortgage insurance (MI). Our model provides improved performance in terms of MI premium pricing, especially during periods that are characterized by high housing prices. Ignoring the impacts of macroeconomic factors on housing prices will lead to an underestimation of MI premia.

INTRODUCTION

The mortgage insurance (MI) system has long been the foundation of housing financial markets; thus, it is essential to properly price MI contracts. Many studies point out that changes in housing prices are a crucial factor in determining MI premia (Kau, Keenan, and Epperson, 1992, 1993, 1995; Chen et al., 2010). Meanwhile, numerous studies have identified a significant relationship between housing prices and macroeconomic factors; see Leung (2004) for a review of macroeconomics and housing. According to the relationship between housing prices and macroeconomic factors, MI premia probably depend on their covariance structure. To the best of our knowledge, the extent to which this covariance structure affects MI premia has not been studied. Therefore, the main objectives of this article are to fill this gap using linear regressions to model the relationship between housing prices and macroeconomic factors and to further examine the impacts of macroeconomic factors on MI premia.

Almost all existing models for pricing MI premia assume that the housing price process follows geometric Brownian motion (Kau, Keenan, and Epperson, 1992, 1993, 1995; Kau and Keenan, 1995, 1996; Bardhan, Karapandza, and Urosevic, 2006). However, this assumption only considers the randomness of housing prices themselves and ignores the comovement between housing prices and macroeconomic factors. Many studies empirically highlight the significant relationship between macroeconomic factors and real estate returns. (1) For example, McCue and Kling (1994) show that macroeconomic factors can explain almost 60 percent of the variation in real estate series. Green (2002) and Chen and Patel (2002) also demonstrate that stock return dynamics are a key determinant of housing price trends. In addition, from the perspective of housing supply, the cost of construction and land acquisition are the main components that determine the cost of houses. Jud and Winkler (2002) find that appreciation in real housing prices is strongly positively related to increases in construction costs. Grimes and Aitken (2010) indicate that land price dynamics influence the relationships among housing supply elasticity, land costs, and housing price dynamics. That is, an increase in land costs or construction costs reduces the supply of new housing, which in turn leads to an increase in housing prices. Consequently, in contrast to the existing literature, this article provides a MI pricing model by focusing on the linear cross-sectional regression relationship between housing prices and macroeconomic factors. Moreover, this article examines the extent to which the macroeconomic factors affect housing prices and MI premia.

This article provides some contributions to the current literature on pricing MI contracts. First, considering the comovement between housing prices and macroeconomic factors, we employ an option-pricing framework with a linear regression relationship to price and hedge MI contracts. Our model can be reduced to the model of Bardhan, Karapandza, and Urosevic (2006) when neglecting the impact of macroeconomic factors on housing prices. Second, based on these empirical and numerical analyses, we demonstrate that the statistically significant determinants of housing price returns include the returns on land price, construction costs, the inflation rate, and the stock price index. …

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