The Risk-Return Relationship in Housing Markets: Financial Risk Versus Consumption Insurance
Posted: 12 Jan 2009 Last revised: 24 Aug 2010
Date Written: December 18, 2008
Standard risk-return tradeoff theory cannot explain why housing return varies with risk positively in some markets but negatively in some other markets. This paper addresses this issue by incorporating two unique features of housing into a standard consumption-based asset pricing model: (1) intertemporal hedging incentives and (2) a kinked housing supply function. The model nests two competing effects of price risk on housing return: a financial risk effect associated with owning risky housing asset, and a consumption insurance effect associated with using the current house to hedge against future housing cost risk. The empirical findings confirm several equilibrium predictions implied by the model. In particular, the variation in housing risk-return relationship across markets is driven by both local households' hedging incentives and housing supply constraints.
Keywords: Housing; Real estate; Consumption-based asset pricing; Risk-return relation
JEL Classification: C32, G12, R0
Suggested Citation: Suggested Citation