Integrating Flood Risk into House Price Models Using Expected Discounted Loss: Evidence from the Czech Republic in 2024

Prices of houses in flood risk zones are subject to a price discount reflecting the risk of losses caused by floods. First, the article establishes a framework for pricing flood risk using the expected discounted loss approach, based on the capital asset pricing model and the Gumbel mixture model of estimated likelihood and impacts of flood risk events. The measure advantage is dimensionality reduction and interpretability. Second, the resulting measure of flood risk is tested to assess whether it can explain differences in house prices using a large data sample from the Czech Republic in 2024. I show that the flood risk measure, expected discounted loss, can be a significant predictor of house prices, but its explanatory power depends critically on the data source used for determining flood risk zones. The results indicate that the market does price flood risk but tends to underestimate its magnitude. Moreover, it does not adjust the weight assigned to flood risk even after severe flood events. Lastly, I discuss the potential use of the obtained flood risk loss distributions for the calculation of Value at Risk and other risk measures of portfolios, including direct real estate or real estate used as collateral.