Keeping an eye on things
The fallacy is very clearly articulated here.
The author correctly states that “the historical evidence can soundly reject the hypothesis that the expected rate of house price inflation is equal to the risk free rate,” then incorrectly states that “the Black Scholes priced put option gives you that expected value if and only if the expected value of house price inflation equals the risk free rate”.
Kevin and I address the fallacy in a forthcoming paper, but I will briefly discuss it here.
Eumaeus is pleased to announce the release of the second edition of our equity release valuation report, THE EUMAEUS GUIDE TO EQUITY RELEASE VALUATION Restating the Case for a Market Consistent Approach.
The new edition involves some simplification and tidying up, including: a simpler treatment of volatility estimation; a simpler treatment of the Market Consistent approach reflecting our more recent work on option pricing (of which more later); a brief discussion of Professor Mario Wüthrich’s 2011 European Actuarial Journal article on market consistent valuation; and a discussion of the IFoA Equity Release Working Party’s magnificently flawed approach (“A Discussion Note on the Economic Valuation of Equity Release Mortgages as Part of the PRA’s Effective Value Test”) to the PRA’s Principle III (“The present value of deferred possession of a property should be less than the value of immediate possession”).
As always, we thank the many people who have contributed to it.
Please keep the comments flowing in through our contact box.
The chart below shows the (indexed) value of the S&P from the beginning of 1920 to the end of 1940, together with the indexed value of dividends. Source is Robert Shiller’s database.
The IFoA working party on equity release mortgages chaired by our friend Craig Turnbull has just issued an interesting ‘discussion note’ about equity release valuation. You might have thought that the WP might have had something to say about some of the rude things we have said about the subject, or about the IFoA or even about the WP itself, but no.
At one level, the WP’s non response is admirable. From a scientific perspective, however, it isn’t helpful to ignore research that gives conclusions they might not like. Better to confront and rebut, otherwise people might be tempted to draw their own conclusions.
There is also nothing about the ostrich elephant in the room, which is whether the industry are getting it wrong, like getting NNEG valuation an order of magnitude wrong.
A great piece here from BBC journalist Howard Mustoe, about an added cost on extending a leasehold with fewer than 80 years remaining, called marriage value.
I discussed the mathematics of the PRA proposal to tie the deferment rate to the real risk free interest rate here, linking to two earlier posts by Kevin with the detailed mathematics. But we can express our result without much of the detailed mathematics, as follows.
Well we said we would be back. Here is the newly released PRA Policy Statement 19/19, and there is some really weird stuff in there. We start with section A, ‘Reviewing and updating the minimum deferment rate,’ and in particular the part which starts at paragraph 2.6, ‘The PRA considers that the approach of linking changes in the minimum deferment rate to changes in real interest rates is economically sound and appropriate for the intended purpose of a diagnostic test.’
They write:
The PRA considered net rental yields in paragraph 2.59 of PS31/18 and agrees that net rental yields could be a reasonable starting point for determining deferment rates over short terms, as they are a measure of the income foregone by an ERM investor as compared to a direct owner of a property. However, a net rental yield is a short-term measure of deferment.
Which is very strange indeed.
Although we have often criticised it, the Discounted Projection aka ‘Real World’ Approach used by the equity release industry to value their NNEGs and ERMs has two significant things going for it. The first is fantastic marketing. Who could be against a ‘real world’ approach, especially when the alternative is a Market Consistent or ‘Risk Neutral’ approach? Everyone knows that most people are not risk-neutral. ‘Real world’ or ‘risk neutral? It’s a no-brainer.
The other thing that the DP/’Real World’ approach has going for it is that it produces much lower valuations. Hosty et alia (2007) hit the nail right on the head:
7.3.3 Market consistent or real world?
On our proxy market consistent approach we have derived a cost for the NNEG which would render the product non-profitable, whilst real world modelling has produced a significantly lower cost.
The importance of commercial considerations as a reason for preferring this approach was confirmed by Tom Kenny at the 28 February 2019 Staple Inn launch event for the Tunaru report. Mr Kenny was the chair of the event, and is Director of Actuarial & Underwriting, Retirement Lending at Just Group plc in his day job: “clearly if we move down a purely market consistent route … it’s going to be extremely expensive,” he said.
Darn right it’s going to be expensive.
… that uses the correct valuation approach. Disclosure: we are two of the co-authors, so we would say that.
The article, “The Valuation of No-Negative Equity Guarantees and Equity Release Mortgages” by Kevin Dowd, David Blake, Dean Buckner and John Fry has just been accepted by the well regarded academic economics journal, Economics Letters.
Continue reading “At Last, a Refereed Article on NNEG Valuation”
Kevin writes here
It also gets interesting if the firms use different valuation approaches from each other. In that case it would be theoretically possible for both parties to post a profit on the transaction or for both parties to post a loss on it.
He is referring to the approaches used to value the embedded put option in the ERM, and the actual put option used to hedge the ERM.
There is a troubling reminder here of what happened to AIG Financial Products in the run-up to the last financial crisis.