Hedging House Price Risk With Incomplete Markets

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.