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

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.     

Distortions in Real Estate Transactions with Out-of-State Participants

Using the MLS and the land registration data from Indiana, this paper identifies and explains price distortions associated with out-of-state sellers and buyers in the housing market. We find that out-of-state buyers pay 20.4% higher prices than local buyers, and the premium is fully explained by the former purchasing larger homes than the latter. On the other hand, out-of-state sellers receive a 21.2% price discount, among which 9.3% is attributable to differences in transactional characteristics, 3.2% is explained by increased motivation and weak bargaining power of out-of-state sellers, and 1.5% is due to differences in agent characteristics and behaviours. The remaining 7.2% discount varies systematically with the informational disadvantage of out-of-state sellers, and with the market condition. Our results are robust to model misspecification.     

Time-varying risk aversion and asset prices

This paper uses a variant of the consumption-based representative agent model in Campbell and Cochrane [Campbell, J.Y., Cochrane, J.H., 1999. By force of habit: Consumption-based explanation of aggregate stock market behavior. Journal of Political Economy 107, 205–251] to study how investors’ time-varying risk aversion affects asset prices. First, we show that a countercyclical variation of risk aversion drives a procyclical conditional risk premium. Second, we show that with a small value for the volatility of the log surplus consumption ratio, a large value of risk aversion may not determine whether the equity premium and the risk-free rate puzzles can be resolved or not. Third, we show that countercyclical risk aversion may not help explain the predictability of long-horizon stock returns, the univariate mean-reversion of stock prices and the “leverage effect” in return volatility.     

Investor behaviour and reaching for yield: Evidence from the sterling corporate bond market

We provide evidence on how corporate bond investors react to a change in yields, and how this behaviour differs in times of market‐wide stress. We also investigate ‘reaching for yield’ across investor types, as well as providing insights into the structure of the corporate bond market. Using proprietary sterling corporate bond transaction data, we show that insurance companies, hedge funds and asset managers are typically net buyers when corporate bond yields rise. Dealer banks clear the market by being net sellers. However, we find evidence for this behaviour reversing in times of stress for some investors. During the 2013 ‘taper tantrum’, asset managers were net sellers of corporate bonds in response to a sharp rise in yields, potentially amplifying price changes. At the same time, dealer banks were net buyers. Finally, we provide evidence that insurers, hedge funds and asset managers tilt their portfolios towards higher risk bonds, consistent with ‘reaching for yield’ behaviour.     

Spot price modeling and the valuation of electricity forward contracts: The role of demand and capacity

We propose a model where wholesale electricity prices are explained by two state variables: demand and capacity. We derive analytical expressions to price forward contracts and to calculate the forward premium. We apply our model to the PJM, England and Wales, and Nord Pool markets. Our empirical findings indicate that volatility of demand is seasonal and that the market price of demand risk is also seasonal and positive, both of which exert an upward (seasonal) pressure on the price of forward contracts. We assume that both volatility of capacity and the market price of capacity risk are constant and find that, depending on the market and period under study, it could either exert an upward or downward pressure on forward prices. In all markets we find that the forward premium exhibits a seasonal pattern. During the months of high volatility of demand, forward contracts trade at a premium. During months of low volatility of demand, forwards can either trade at a relatively small premium or, even in some cases, at a discount, i.e. they exhibit a negative forward premium.     

Loss aversion,asymmetric market comovements,and the home bias

Loss aversion has been used to explain why a high equity premium might be consistent with plausible levels of risk aversion. The intuition is that the first-order-different utility impact of wealth gains and losses leads loss-averse investors to behave similarly to investors with high risk aversion. But if so, should those agents not perceive larger gains from international diversification than standard expected-utility investors with plausible levels of risk aversion? They might not, because comovements in international stock markets are asymmetric: correlations are higher in market downturns than in upturns. This asymmetry dampens the gains from diversification relatively more for loss-averse investors. We analyze the portfolio problem of such an investor who has to choose between home and foreign equities in the presence of asymmetric comovement in returns. Perhaps surprisingly, in the context of the home bias puzzle we find that loss-averse investors behave similarly to those with standard expected-utility preferences and plausible levels of risk aversion. We argue that preference specifications that appear to perform well with respect to the equity premium puzzle should be subjected to this “test”.     

Sales Concessions in the US Housing Market

This article examines the use of concessions in the US housing market, specifically payments for closing costs, home warranties, and structural repairs. This is the first study to examine the motivations and characteristics of homeowners that utilize concessions. It also examines the impact concessions have on transaction prices and marketing durations. While the literature has attempted to determine if concessions can reduce marketing durations or increase transaction prices, the evidence is tainted by endogeneity and sample issues. Additionally, we find that relative bargaining power between buyers and sellers has a fundamental effect on how concessions alter prices and marketing durations. This aspect has been considered only narrowly in the extant literature. Our results demonstrate that when sellers have bargaining power, transactions including concessions exhibit higher prices and shorter marketing durations. Conversely, when buyers have greater negotiation leverage, transactions including concessions experience lower prices and longer marketing periods.     

Preference heterogeneity and asset prices: An exact solution

We introduce a general equilibrium model of a multi-agent, pure-exchange economy and find a set of conditions that enable us to obtain explicit closed-form solutions to the equilibrium interest rate, stock price, risk premium and stock market volatility when investors have heterogenous risk aversions. Because the market is dynamically complete, full risk sharing obtains and a representative agent can be constructed, though the risk aversion of this agent fluctuates over time with the state of the economy, as the relative wealth distribution of the individual investors changes. We show that preference heterogeneity can cause asset prices to be significantly more volatile than the underlying dividends and that it can lead to leverage-like effects in volatility, in the sense that volatility increases after stock-market declines.     

Selling price,financing premiums,and days on the market

Home buyers face the task of trading off selling price and the time required to sell a property. One factor that may affect this decision is the presence of financing premiums. The effects of financing premiums on the time a single-family home remains on the market is examined in this paper. The question is to what extent home sellers are willing to compromise on financing premiums and make concessions to buyers in order to sell their properties more quickly.The study uses a sample of single-family residential homes sold with assumption financing and new conventional financing. The sample covers segments of time when interest rates were relatively low and stable (1975–1976) and when rates were much higher on average and more volatile (1980).The results show that financing premiums were present in selling prices of assumption-financed home sales during the 1975–1976 period and that sellers were able to capture a premium and maintain the same average time on the market as properties with other types of financing. During a period of unfavorable market conditions, such as 1980, the results indicate that home sellers with assumption financing conceded or negotiated away any premium in order to significantly decrease the number of days their properties stayed on the market for sale.     

Disagreement and asset prices

How do differences of opinion affect asset prices? Do investors earn a risk premium when disagreement arises in the market? Despite their fundamental importance, these questions are among the most controversial issues in finance. In this paper, we use a novel data set that allows us to directly measure the level of disagreement among Wall Street mortgage dealers about prepayment speeds. We examine how disagreement evolves over time and study its effects on expected returns, return volatility, and trading volume in the mortgage-backed security market. We find that increased disagreement is associated with higher expected returns, higher return volatility, and larger trading volume. These results imply that there is a positive risk premium for disagreement in asset prices. We also show that volatility in and of itself does not lead to higher trading volume. Instead, only when disagreement arises in the market is higher uncertainty associated with more trading. Finally, we are able to distinguish empirically between two competing hypotheses regarding how information in markets gets incorporated into asset prices. We find that sophisticated investors appear to update their beliefs through a rational expectations mechanism when disagreement arises.     

The price of power: The valuation of power and weather derivatives

Pricing contingent claims on power presents numerous challenges due to (1) the unique behavior of power prices, and (2) time-dependent variations in prices. We propose and implement a model in which the spot price of power is a function of two state variables: demand (load) and fuel price. In this model, any power derivative price must satisfy a PDE with boundary conditions that reflect capacity limits and the non-linear relation between load and the spot price of power. Moreover, since power is non-storable and demand is not a traded asset, the power derivative price embeds a market price of risk. Using inverse problem techniques and power forward prices from the PJM market, we solve for this market price of risk function. During 1999–2001, the upward bias in the forward price was as large as $50/MWh for some days in July. By 2005, the largest estimated upward bias had fallen to $19/MWh. These large biases are plausibly due to the extreme right skewness of power prices; this induces left skewness in the payoff to short forward positions, and a large risk premium is required to induce traders to sell power forwards. This risk premium suggests that the power market is not fully integrated with the broader financial markets.     

Endogenous housing market cycles

Housing markets tend to display positive serial correlation as well as considerable volatility over time. We present a heterogeneous agent model illustrating the connection between adaptive expectations and housing market fluctuations. A dwelling serves as a shelter, as a vehicle for investment and as mortgage collateral. Interesting dynamics arise as the valuation of these three properties changes over time through the interaction of buyers, sellers and mortgagees. In the absence of credit constraints imposed by mortgagees, house prices oscillate mildly around the equilibrium price. However, credit constraints imposed by mortgagees can affect market dynamics quite dramatically with periods of mild oscillations interrupted by violent collapses. This chaotic behavior arises even though buyers, sellers and mortgagees agree on market forecasts.     

Age‐Dependent Increasing Risk Aversion and the Equity Premium Puzzle

We introduce a new preference structure—age‐dependent increasing risk aversion (IRA)—in a three‐period overlapping generations model with borrowing constraints, and examine the behavior of equity premium in this framework. We find that IRA preferences generate results that are more consistent with U.S. data for the equity premium, level of savings and portfolio shares, without assuming unreasonable levels of risk aversion. We find that the relative difference between the two risk aversions (how much more risk‐averse old agents are relative to the middle‐aged) matters more than the average risk aversion in the economy (how much more risk‐averse both cohorts are). Our findings are robust with respect to a number of model generalizations.     

Derivative Pricing with Liquidity Risk: Theory and Evidence from the Credit Default Swap Market

We derive an equilibrium asset pricing model incorporating liquidity risk, derivatives, and short‐selling due to hedging of nontraded risk. We show that illiquid assets can have lower expected returns if the short‐sellers have more wealth, lower risk aversion, or shorter horizon. The pricing of liquidity risk is different for derivatives than for positive‐net‐supply assets, and depends on investors' net nontraded risk exposure. We estimate this model for the credit default swap market. We find strong evidence for an expected liquidity premium earned by the credit protection seller. The effect of liquidity risk is significant but economically small.     

Information, Search, and House Prices: Revisited

Buyers pay different prices for nearly identical homes. One explanation for this is that housing markets are thin, resulting in price bargaining between sellers and buyers. If the relative bargaining power of buyers varies, so will sales prices. One hypothesis is that the relative bargaining strength of buyers coming from outside the local market relative to that of local residents is weak, because distant buyers have high search costs and may know less about the nuances of the local market. Our results, based upon a large number of single-family home transactions from the state of Florida, lend support to this hypothesis. Another related hypothesis is that buyers?? price expectations are anchored to prices they were accustomed to at their previous residence. Hence, if they come from high price markets they will tend to pay more for their new home. This hypothesis is also supported by our results.     

Risk,uncertainty, and asset prices

We identify the relative importance of changes in the conditional variance of fundamentals (which we call “uncertainty”) and changes in risk aversion in the determination of the term structure, equity prices, and risk premiums. Theoretically, we introduce persistent time-varying uncertainty about the fundamentals in an external habit model. The model matches the dynamics of dividend and consumption growth, including their volatility dynamics and many salient asset market phenomena. While the variation in price–dividend ratios and the equity risk premium is primarily driven by risk aversion, uncertainty plays a large role in the term structure and is the driver of countercyclical volatility of asset returns.     

Asymmetric information and the death of ABS CDOs

A key feature of the 2007 financial crisis is that for many securities trading had ceased; where trading did occur, market prices were well below intrinsic values, especially for ABS CDOs. One explanation is that information had been asymmetric, with sellers having better information than buyers. We first show the information advantages sellers had over buyers in both the issuance of CDOs and, through vertical integration, performance of the CDO collateral that could well have disrupted trading after the onset of the crisis. Using a “workhorse” model for pricing securities under asymmetric information and a novel dataset, we show how adverse selection could explain why the bulk of these securities either traded at significant discounts or did not trade at all.     

Search Costs,Behavioral Biases,and Information Intermediary Effects

In many markets, buyers, sellers, and their agents have differential information about the quality of heterogeneous assets. We study negotiated transaction prices in the commercial real estate market, which is characterized by heterogeneous assets, illiquidity, and highly segmented local markets, all of which increase the importance of asymmetric information in negotiated pricing outcomes. Using 114,588 industrial, multi-family and office sale transactions that occurred during 1997–2011, we document that distant commercial real estate buyers pay, on average, premiums of 4 % to 15 % relative to local buyers, controlling for individual property characteristics as well as time fixed-effects. We also examine the extent to which the sources of these observed premiums are a product of higher search costs/information asymmetry problems associated with distance (search cost channel) or a result of reference-dependence preference/anchoring based on the price levels in the investors’ local market (behavioral biases channel). Our results suggest the observed price premiums are explained by distant investors who face higher search costs and are at an information disadvantage compared to investors located in closer proximity to the property. In contrast, anchoring plays a more muted role in explaining observed premiums. The use of an intermediary (broker) increases, on average, the acquisition prices of buyers and decreases the disposition prices of sellers by 3 % to 8 %. This result is consistent with the incentive real estate agents have to convince sellers to dispose of their properties too quickly and to convince buyers to search less and therefore pay higher prices.     

Price Effects of Non-Traditionally Broker-Marketed Properties

This study investigates whether or not non-traditional marketing has an effect on the prices paid for residential real estate. Non-traditionally broker-marketed properties are defined as those properties that are sold with the aid of a real estate broker, but not marketed through a Multiple Listing Service (MLS). An analysis of properties that sold in this fashion offers further insight into the intermediation role of the real estate broker, as well as an opportunity to further investigate the efficiency of residential real estate markets. Specifically, we can assess whether MLS participation generates higher prices by determining whether like-kind properties price equivalently despite differences in their mode of marketing. The results show a significant and positive impact by non-traditionally broker-marketed properties on property price suggesting, for this sample, a premium of over 6% compared to like-kind properties marketed through the MLS. This premium may be a result of brokers intermediating a better matching of buyers and sellers. The observed premium also suggests a degree of market inefficiency.     

The forward premium in electricity futures

Understanding the nature of the forward premium is particularly crucial, but rather elusive, for a non-storable commodity such as wholesale electricity. Whilst forward prices emerge as the expectation of spot plus, or minus, an ex ante premium for risk, the manifestation and empirical analysis must focus upon realised ex post premiums. This presents modelling requirements to control for shocks to the spot expectation as well as the endogeneity of ex post premia with spot price outcomes. In addition, because electricity is a derived commodity in the sense that market prices are often set by technologies that convert gas or coal into power, it is an open question whether much of the premia in power may actually be a pass-through of the premia in gas (or coal). Using a four dimensional VAR model we are able to distinguish fundamental and behavioural aspects of price formation in both the daily and monthly forward premia from the British market. We present new evidence on daily and seasonal sign reversals, associated with demand cycles, the greater importance of behavioural adaptations in the risk premia than fundamental or spot market risk measures, and the substantial fuel risk pass-through. We also show the value of a nonlinear specification in this context.