Housing, Risk Aversion and Asset Prices

Abstract

By extending Cumulant Generating Function-based pricing formulas to a two-good economy (non-housing and housing), we obtain closed-form solutions for asset prices. The presence of housing impacts risk aversion and induces time variation that is priced in the model. Since housing also brings about composition risk, we show that it introduces endogenously a long-run risk component into the consumption bundle dynamics. Estimating the model over the period 1959 -– 2020, we show that rare booms and busts events in housing expenditures is determinant in obtaining moderate housing risk premium and housing excess return volatility, both in line with empirical results. The real interest rate and both the level and volatility of the equity risk premium also fit the data owing to the presence of the COVID period into our sample period.