Optimal Portfolio Choices, House Risk Hedging and the Pricing of Forward House Transactions

Abstract

This paper develops a utility indifference model for evaluating various prices associated with forward transactions in the housing market, based on the equivalent principle of expected wealth utility derived from the forward and spot real estate markets. Our model results show that forward transactions in the housing market are probably not due to house sellers’ and buyers’ heterogeneity, but to their demand for hedging against house price risk. When the imperfections of real estate markets and the risk preferences of market participants are taken into consideration, we are able to show that the idiosyncratic risk premium, which mainly depends on the participants’ risk preferences and the correlation between the traded asset and the real estate, is a remarkable determinant of house sellers’ and buyers’ forward reservation prices. In addition, we also find that the market clearing forward price usually will not converge toward the expected risk-neutral forward price. The sellers’ or buyers’ risk aversion degrees and market powers are also identified to play crucial roles in determining the clearing forward price..

Keywords: House Risk, Optimal Portfolio, Forward Transactions, Utility Maximization, Incomplete Markets

JEL Classification: G1, R2