Housing, consumption and asset pricing

Abstract

This paper considers a consumption-based asset pricing model where housing is explicitly modeled both as an asset and as a consumption good. Nonseparable preferences describe households' concern with composition risk, that is, fluctuations in the relative share of housing in their consumption basket. Since the housing share moves slowly, a concern with composition risk induces low frequency movements in stock prices that are not driven by news about cash flow. Moreover, the model predicts that the housing share can be used to forecast excess returns on stocks. We document that this indeed true in the data. The presence of composition risk also implies that the riskless rate is low which further helps the model improve on the standard CCAPM.

Asset Pricing Kernels in an OLG Economy with Housing

“…As mentioned in Introduction, Piazzesi, Schneider and Tuzel (2007) introduce composition risk relating change in asset prices to expenditure share and show improved performance by the composition risk factor. Fillat (2008) furthermore analyzes long run risk from composition risk, showing that presence of housing increases the price of the long run risk.…”

“…Therefore it is clear that through the asset pricing kernel, asset prices are linked to the household's marginal utility of consumption over time. For the CES aggregator in the model, the pricing kernel with consumption as numeraire is (Note 13): (20) As Piazzesi et al (2007) argue, the CES aggregator gives a pricing kernel that represents the composition risk. In equation (20), the pricing kernel is not only determined by the usual consumption growth but also by the consumption ratio growth: ratio between the two arguments of goods and housing services and the growth between the two periods of young and old.…”

“…Housing has several important implications in economics and finance. First, housing (or broadly defined as real estate) may be by far the largest component of household total wealth (Ivan, 2012) and its expenditure comprises a substantial share in household expenditure as well (Piazzesi et al, 2007). Second, the value of housing capital stock is larger than that of business capital (Tibaijuka, 2009).…”

“…The main implication is that, when consumption growth rate is high, the IMRS gets lower due to a decreasing marginal utility and thus the future asset value in the high state should be lower. In this sense, the standard C-CAPM may be called consumption risk approach (Piazzesi et al, 2007).…”

“…We may even think about behavioral approaches or beliefs. Staying away from these, Piazzesi et al (2007), by introducing housing explicitly as an asset and upgrading the separable utility specification to non-separable one, replace the old consumption risk with the composition risk (Note 7). They find that the presence of composition risk helps generate a sizeable and volatile equity premium observed in the data.…”