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Hedging House Price Risk With Incomplete Markets

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  • Joao Cocco

    (London Business School)

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    Abstract

    This paper studies the effects of house price risk on the optimal asset and consumption choices of a finitely lived investor who derives utility from the consumption of both housing and other goods. Frictions considered in the model include transaction costs of selling a house, uninsurable labor income risk and borrowing constraints. I find that transaction costs of selling a house reduce consumers' ability to use assets to buffer the effects of income shocks on consumption. Positive correlation between income shocks and house price shocks restricts investors' ability to time their asset choices, leads to higher leverage, and crowds out housing investment. In the presence of positive correlation housing equity and borrowing capacity are reduced at times when the marginal utility of consumption is large. The effects of positive correlation on investor welfare are particularly large for moderate levels of risk aversion.

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    Bibliographic Info

    Paper provided by Society for Computational Economics in its series Computing in Economics and Finance 2000 with number 317.

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    Date of creation: 05 Jul 2000
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    Handle: RePEc:sce:scecf0:317

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    Postal: CEF 2000, Departament d'Economia i Empresa, Universitat Pompeu Fabra, Ramon Trias Fargas, 25,27, 08005, Barcelona, Spain
    Fax: +34 93 542 17 46
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    Web page: http://enginy.upf.es/SCE/
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    Cited by:
    1. François Ortalo-Magné & Matteo Iacoviello, . "Hedging Housing Risk in London," Wisconsin-Madison CULER working papers 02-03, University of Wisconsin Center for Urban Land Economic Research.
    2. Charles Himmelberg & Christopher Mayer & Todd Sinai, 2005. "Assessing High House Prices: Bubbles, Fundamentals, and Misperceptions," NBER Working Papers 11643, National Bureau of Economic Research, Inc.
    3. Todd Sinai & Nicholas S. Souleles, 2005. "Owner-occupied housing as a hedge against rent risk," Working Papers 05-10, Federal Reserve Bank of Philadelphia.
    4. Joseph B. Nichols, 2007. "Nominal mortgage contracts and the effects of inflation on portfolio allocation," Finance and Economics Discussion Series 2007-67, Board of Governors of the Federal Reserve System (U.S.).
    5. Hanno Lustig & Stijn Van Nieuwerburgh, 2003. "Housing Collateral, Consumption Insurance and Risk Premia: An Empirical Perpective," NBER Working Papers 9959, National Bureau of Economic Research, Inc.
    6. Juerg Syz & Paolo Vanini & Marco Salvi, 2008. "Property Derivatives and Index-Linked Mortgages," The Journal of Real Estate Finance and Economics, Springer, vol. 36(1), pages 23-35, January.
    7. Ricardo M. Sousa, 2009. "Wealth Effetcs on Consumption: Evidence from the euro area," NIPE Working Papers 12/2009, NIPE - Universidade do Minho.
    8. Ricardo M. Sousa, 2007. "Wealth Shocks and Risk Aversion," NIPE Working Papers 28/2007, NIPE - Universidade do Minho.
    9. Černý, Aleš & Miles, David & Schmidt, L'Ubomír, 2010. "The impact of changing demographics and pensions on the demand for housing and financial assets," Journal of Pension Economics and Finance, Cambridge University Press, vol. 9(03), pages 393-420, July.
    10. Luca Benzoni & Pierre Collin-Dufresne & Robert S. Goldstein, 2005. "Portfolio Choice over the Life-Cycle in the Presence of 'Trickle Down' Labor Income," NBER Working Papers 11247, National Bureau of Economic Research, Inc.
    11. Nicolas R. Blancher & François Haas & John Kiff & Oksana Khadarina & Paul S. Mills & Parmeshwar Ramlogan & William Lee & Yoon Sook Kim & Todd Groome & Shinobu Nakagawa, 2006. "The Limits of Market-Based Risk Transfer and Implications for Managing Systemic Risks," IMF Working Papers 06/217, International Monetary Fund.
    12. Hanno Lustig & Stijn Van Nieuwerburgh, 2002. "Housing Collateral, Consumption Insurance and Risk Premia," Macroeconomics 0211008, EconWPA.
    13. Hanno Lustig, 2004. "Housing Collateral, Consumption Insurance and Risk Premia: an Empirical Perspective (joint with Stijn Van Nieuwerburgh), forthcoming Journal of Finance," UCLA Economics Online Papers 300, UCLA Department of Economics.
    14. Ortalo-Magne, Francois & Rady, Sven, 2002. "Tenure choice and the riskiness of non-housing consumption," Journal of Housing Economics, Elsevier, vol. 11(3), pages 266-279, September.
    15. Joseph Nichols, 2004. "A Life-cycle Model with Housing, Portfolio Allocation, and Mortgage Financing," Econometric Society 2004 North American Winter Meetings 205, Econometric Society.

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