OPTIMAL TIMES TO BUY AND SELL A HOME

Abstract

We consider a financial market in which the risk-free rate of interest is modeled as a Markov diffusion. We suppose that home prices are set by a representative homebuyer, who can afford to pay only a fixed cash flow per unit time for housing. The cash flow is a fraction of the representative homebuyer’s salary, which grows at a rate that is proportional to the risk-free rate of interest. As a result, in the long run, higher interest rates lead to faster growth of home prices. The representative homebuyer finances the purchase of a home by taking out a mortgage. The mortgage rate paid by the homebuyer is fixed at the time of purchase and equal to the risk-free rate of interest plus a positive constant. As the homebuyer can only afford to pay a fixed cash flow per unit time, a higher mortgage rate limits the size of the loan the homebuyer can take out. As a result, the short-term effect of higher interest rates is to lower the value of homes. In this setting, we consider an investor who wishes to buy and then sell a home in order to maximize his discounted expected profit. This leads to a nested optimal stopping problem. We use a nonnegative concave majorant approach to derive the investor’s optimal buying and selling strategies. Additionally, we provide a detailed analytic and numerical study of the case in which the risk-free rate of interest is modeled by a Cox–Ingersoll–Ross (CIR) process. We also examine, in the case of CIR interest rates, the expected time that the investor waits before buying and then selling a home when following the optimal strategies.