Underlying Economics

The Equity Risk Premium

To understand the economic 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 7 percent per annum – as to which click here.

The Excess Risk Premium

We observed that a margin of 3 to 7 percent over the Risk Free Rate is typically greater than the margin paid by a prime mortgage borrower over that same rate. And so we wondered whether the Equity Risk Premium might be put to work for the benefit of homeowners, by way of a reduction in the mortgage interest rate.  Hence we became interested in the relationship between mortgage rates and equity market returns.

We considered that relationship by reference to Prime Borrower Home Lending Rates and the Total Return of the equities market and observed that, over over the medium to long term, there was a high probability of a positive difference between the Total Return and Prime Borrower Home Lending Rates.

We call this difference the Excess Risk Premium.  To read more about the Excess Risk Premium and the effect of its accumulation over time click here to download a PDF file.

Diagram: Index Performance is the sum of capital growth and dividend yield, reported as a Total Return before tax.  It may be deconstructed into: (a) the Risk Free Rate plus the realised Equity Risk Premium; or (b) the Prime Borrower Home Lending Rate plus the Excess Risk Premium

We developed a mechanism to efficiently accumulate the Excess Risk Premium and to apply the accumulated excess 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.

“What a story. … From all perspectives the Index Mortgage is an exciting development, one which could revolutionise the mortgage market.”

Citigate Dewe Rogerson, LaunchSure Report