The Blackwell Companion to the Economics of Housing: The Housing Wealth of Nations edited by Susan J. Smith and Beverley A. Searle, chapter 21, forthcoming, 2010.

Trading on house price risk Index derivatives and home equity insurance

Peter Englund Stockholm School of Economics and University of Amsterdam

Recent developments of public sector welfare systems and financial markets offer new incentives as well as new opportunities for households to make active financial decisions. New financial instruments and better functioning markets facilitate hedging health and income risks. The well informed and rational individual can now actively trade off risk against expected returns. Still some of the major risks in life remain difficult to affect, those associated with housing choices being perhaps the most conspicuous example. For most households buying their home is the major investment in life and the home is the major asset in the wealth portfolio of most households. But this is an investment driven by consumption motives rather than by risk-and-return considerations. Households choose to own because the ownership market offers them more flexibility of choice and because owning solves some basic agency problems that are not well handled by a rental contract. Households choose the amount of housing investment out of consumption needs rather than by thinking about optimal portfolio composition. As a result many households end up with very unbalanced portfolios with several hundred percent of their net wealth invested in . While this might be optimal from a risk-and-return perspective for some households, it is certainly not universally so.

Modern financial technology should be useful also for trading in housing risk. In this chapter I will discuss how financial derivatives could be used to enable households to disentangle consumption from investment decisions and to adjust their exposure to housing risk without any consequences for their consumption of housing services. The next section gives a short introduction to the importance of housing in household wealth portfolios. This is followed in section 2 by a characterization of the risk and return of housing as an investment object. The following two sections provide a brief analysis, drawing on the recent academic

1 literature, of the potential gains if households could trade in financial instruments related to house price indexes. Finally, section 5 reviews current market experiences and proposals to create new products and index derivatives markets. Section 6 concludes with a brief discussion of likely future developments.

1. The owned home in household portfolios In economic analysis, we typically distinguish between investment and consumption decisions. For housing, however, these two decisions are intertwined. In principle, they can be disentangled by making the consumption choice through renting housing services and the investment choice by purchasing some form of real estate securities. In practice, most households aspire to own their home for reasons not primarily related to investment returns. In industrialized countries 6 out of 10 households are homeowners. This average conceals large differences across countries, from lows of 30-40 percent in Switzerland and Germany to highs of round 80 percent in Spain and Ireland. In many countries – such as the United States – a high rate of homeownership is an explicit political goal and tax policies and mortgage market institutions are directed at easing access to homeownership. In other countries – like Sweden – stated policy objectives indicate neutrality towards the choice between owning and renting.

In practice, transaction costs and the availability and cost of mortgage finance are probably the most important factors explaining the differences in homeownership across countries.1 In many countries the tax deductibility of mortgage interest payments is not fully offset by taxes or other taxes on the returns to homeownership, whereas the taxation of the rental sector tends to be approximately neutral. In most countries the fraction of homeowners has been increasing in recent decades, largely as a result of improved borrowing opportunities following deregulation and technological innovations in the financial industry. This development has probably been welfare-enhancing by allowing access to homeownership for many low-income households previously locked out from this market by high downpayment requirements. But, as witnessed by the current sub-prime mortgage crisis, it has exposed many of these households to new risks that they are ill-prepared for.

2. How risky is housing?

1 See, e.g., Hilber (2007) for a study of the determinants of ownership rates across Europe.

2 Homeowners are well aware that house prices fluctuate. Under normal conditions this may not be a major concern for current owners, as long as it does not directly affect their housing expenditures. In fact, rising prices may even be seen as bad news insofar as they affect the base for property taxes. House price fluctuations do, however, become of more direct concern for anybody who considers moving from one area to the other, as price movements are often not well coordinated across regions. In fact, it seems that variations in overall housing price levels coincide with variations in relative prices. As one illustration, figure 1 depicts an index of the relative price between a Scotland and a London one-family house. During the two periods (1983-88 and 1996-2002) when house prices in general sky-rocketed in all of the United Kingdom, the London price level doubled relative to that of Scotland. In the years in between, on the other hand, both absolute and relative prices moved in the opposite direction. In 1993 the price of a London home relative to a Scotland home was back at the 1983 level. Clearly, such fluctuations represent substantial risks with an enormous impact on the distribution of life-time resources across households with different patterns of mobility.

In order to analyze the riskiness of homeownership in more detail, we need to first discuss how to measure the returns to owning a home. The returns consist of two main components: the capital gains (and losses) and the value of the housing services enjoyed by living in the house (the implicit rent that the homeowner “pays to himself”). The capital gains cannot be observed with any precision until the house is sold and the gains (or losses) are realized. Yet, they make up an important and risky part of returns and to assess the full risks of housing we need to measure the gains per period as they accrue during the holding period. Returns can be measured using (the log difference of) price indexes constructed based on observed transaction prices. In such indexes, the heterogeneous nature of houses is accounted for either by hedonic regressions or by repeat-sales estimates (or with some combination of the two). It is important to emphasize that house price indexes are statistical constructs valid for a representative house. They are not exact measures directly applicable to an individual house, nor do they measure the price and returns of a well defined continuously traded portfolio of properties analogous to, e.g., stock price indexes. Rather, they should be interpreted as measures of the development of expected sales prices for a representative house.

There are at least three important differences between a house price index and a stock index that are important to keep in mind when comparing return properties and discussing the viability of various index related derivatives. First, it is not possible to trade directly in the

3 portfolio of properties underlying the house price index. While this problem may not matter for index construction, it is a strong deterring factor in developing a market in index derivatives. Second, house price indexes are always measured with error. Third, the returns as indicated by price index changes do not account for the idiosyncratic risk associated with an individual house due to unique characteristics of the house as well as the special nature of the transaction when a house is traded.

The other component of returns, the implicit rent, is also fraught with measurement problems. The natural approach would seem to be to use market rents, in which case the measurement problems would “only” be those related to the heterogeneity of dwellings, i.e. in principle the same problems as with price indexes. Unfortunately, rent indexes have the added problem that rental markets are often regulated or otherwise poorly functioning. In fact, they may be close to non-existent for one-family houses in many countries. Furthermore, even in unregulated rental markets observed rent variations are restricted by long-term contracts, and fluctuations in vacancies is an important equilibrating mechanism. In practical calculations of housing returns, implicit rents are often measured by simple rules of thumb, such as a fixed percentage of market prices. As a result, the variability of housing returns is likely to be understated. This may not be too serious, however, since the “cap rate” that translates prices into implicit rents is likely to have a low variance relative to the capital-gains component of housing returns. In terms of providing inputs to a portfolio choice problem, it is probably more problematic that the level of rents, and hence expected returns, is based on such ad hoc assumptions.

Bearing these caveats in mind, a number of authors – e.g. Goetzmann (1993), Flavin and Yamashita (2002) for the U.S., Englund, Hwang and Quigley (2002) for Stockholm, Iacoviello and Ortalo-Magné (2003) for London, and le Blanc and Lagarenne (2004) for Paris have computed the means and variances of housing returns. Generally speaking, they all find that housing is an average asset with mean returns and variance higher than for bonds but lower than for stocks. Estimates of mean return vary quite a bit across studies, however, partly reflecting the particular sample period. As an example, the London data used by Iacoviello and Ortalo-Magné refer to an extended boom period. Furthermore, housing returns appear to have a generally low correlation with other assets, making housing attractive in a well- diversified portfolio. Measures of correlation should be interpreted with caution, however, as they are likely to be biased toward zero because of measurement errors in the underlying price index.

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3. The gains from being able to invest in a housing index – a first look The return characteristics reported by the authors referred to in the previous section indicate that housing is not an unattractive asset from a portfolio perspective. Applying standard mean-variance analysis to the data presented in the studies mentioned in the previous section yield optimal housing portfolio shares in the minimum-variance portfolio on the order of 30- 70% of the net wealth (assets minus debt). This can be compared with observed portfolio shares. According to Flavin and Yamashita (1998, tab. 2) the average US home-owner has a portfolio share around 150% with many young households at much higher levels. Compared to the benchmark provided by the mean-variance model, the average renter is under-invested and the average home owner is over-invested in housing. Both household categories would stand to gain from access to a market that allowed them to freely adjust their housing portfolio share.

How costly is the absence of markets that would allow them to adjust their exposure to house price risk? What are the costs of today’s market incompleteness in terms of excessive risk taking or returns foregone? Let us make the following thought experiment. Consider a representative highly leveraged home-owner with, say, 400% of her net wealth invested in a house (typical for less wealthy home-owners in countries with well-developed mortgage markets) and a representative renter with zero housing investment. Now, assume that we introduce the possibility to trade in the housing index and ask how this opportunity would impact on the combinations of expected return and variance that are available to our hypothetical household.

Answers to this thought experiment in the form of attainable combinations of risk and return – efficient frontiers to use the language of portfolio theory – are depicted in Figures 2 and 3, constructed based on Swedish data as reported in Englund, Hwang and Quigley (2002). Before discussing the graphs, there are two things to note. First, this example accounts for the availability of other marketable assets, apart from the house price index, that are correlated with house prices. In particular, the menu of assets includes shares in property companies quoted on the Stockholm stock exchange. In the U.S. and other economies, real estate investment trusts (REITs) would be a natural investment alternative. Second, the calculations account for the fact that the returns to an individual house include an idiosyncratic component

5 that is not captured by the price index. The variance of this component – as estimated by Englund, Quigley and Redfearn (1998) – is quite large. According to those estimates the quarter-by-quarter variance of the returns to an individual house is about five times as large as that of the price index. The relative importance of the idiosyncratic component diminishes over time, however, and at a 5 or 10 year horizon the variance in return to an individual house is only about twice that of the index.2

Figure 2 depicts two different efficient frontiers for a hypothetical home owner with 400 % of her net wealth invested in her home. It holds the housing investment fixed and allows the investment in other assets to vary so as to attain the best possible combinations of risk and return. The curve to the right illustrates the situation when our home owner is restricted to a standard set of investments apart from the own home – treasury bills, bonds, common stocks and property company stocks. It shows how she may trade off reductions in risk against reductions in expected returns. Because of the leverage effect due to the combination of a large housing investment with indebtedness, our homeowner cannot avoid facing quite a bit of risk. In fact, it is not possible to bring down the standard deviation below 37 %, at which level the expected return is only 2.3 %. With some more appetite for risk it is possible to increase the expected return, e.g. to 8% at 57% standard deviation. The curve to the left illustrates corresponding combinations of risk and return when it is also possible to trade in a house price index.3 The homeowner now wants to take a short position in the index in order to hedge against the risk of falling house prices. A very risk averse homeowner can now reduce the standard deviation down to 24%. At a 37% standard deviation – the minimum possible with index trading – he can now get an 8% expected return, compared to 2.3% in the absence of index trading.

Having access to index related products is also attractive for renters. Analogous efficient frontiers for a hypothetical renter with zero house investment are depicted in figure 3. At very low risk levels the difference between the two frontiers is very small. The reason is that it is possible to achieve virtually zero risk by only investing in treasury bills. At higher risk levels, however, also renters stand to gain by investing in an index. At 20% standard deviation the expected return increases from 6.3% without index trading to 7.1% if the renter is allowed to

2 Other studies, such as Goetzmann (1993), find more persistence in the idiosyncratic component. 3 For simplicity the calculations assume direct trade in the index itself rather than in an index-linked future or option. Presuming that liquid such markets exist, futures and option prices should be highly correlated with the underlying index.

6 invest in a house price index. All these calculations cannot be taken as more than illustrative, but they do suggest that opening a market for trade in housing price indexes should have positive welfare consequences, for renters as well as owners.

4. A Richer Framework The static mean-variance model allows us to have a first shot at understanding the risk exposure of homeowners, but it is strongly oversimplified in crucial respects. An obvious limitation is that the return is only evaluated in terms of end-of-period wealth. But in a dynamic setting owning one’s home offers insurance against future housing consumption risks as emphasized by Sinai and Souleles (2005). For a household planning to stay in its current housing market the entire life, the development of house prices may not be much of a concern. An owner could afford to stay in the same house no matter what the development of house prices. A renter, on the other side, would have to cut down on the consumption of other goods as a consequence of future rent increases.

In general one needs to distinguish two types of risk: an investment risk and a consumption risk. The investment risk can be hedged by a short position in the current housing market (by selling a price index), whereas the consumption risk would be hedged by taking a long position (holding property) in those markets where the household expects to live in the future. For a household that assigns zero probability to ever changing housing market these two hedging demands exactly cancel each other. On the other hand, a household that is certain of moving next year would obtain an investment hedge by shorting its current market and a consumption hedge by going long in the market of destination. In general, rational households should assign probabilities to a variety of housing careers and adjust their exposures according to these probabilities. A recent working paper by Voicu (2007) provides a detailed analysis of optimal portfolio choice with investment and consumption risk in the presence of housing index derivatives.

Another shortcoming of the standard application of the static model is that it disregards other sources of uncertainty than the returns to the various financial assets included in the portfolio choice problem. It treats the house as a predetermined “background” investment, but it does not account for other sources of background risk. The most important such risk is related to

7 future labour income streams, i.e. to the returns to human capital. Omitting income risk from the analysis may lead to misleading conclusions, since human capital and housing tend to be positively correlated. This correlation is likely to be particularly strong in “company towns”, where the labour and housing markets are dominated by a particular industry or even a single employer. The standard calculation underlying figs 2 and 3 portrays housing as a rather attractive asset, since it is essentially uncorrelated with stocks and bonds. But an individual working for the main employer in a company town is already exposed to local labour market risk. By owning his home he would get doubly exposed. Hence, this would cause his hedging needs to be even stronger than the standard analysis suggests.

Interestingly, it seems that households tend to take the correlation between housing and human capital into account in choosing mode of tenure. Research by Davidoff (2006) and Jansson (2008) indicates that the stronger this correlation the less likely households are to own their homes. Jansson employs data on a large panel of Swedish households to estimate the risk of becoming unemployed (the most important human capital risk). Using the estimated equation, he computes a time series of unemployment risks for each household based on the household head’s age, education, place of residence etc. and uses this series to calculate, for each household, the correlation with a local house price index. It turns out that for the great majority of households this correlation is negative (implying a positive correlation between the returns to human capital and housing). The median correlation is as high as -0.6. Jansson then estimates a probit equation of household choice of owning versus renting and finds that the correlation between house prices and unemployment has a significantly negative impact on the probability of being a homeowner. The quantitative effect is rather small, however, and many households remain overexposed to local labour market risks.

Accounting for mobility and income risk is certainly very important in understanding the potential severity of house price risk at the level of an individual household. The simple one- period portfolio model is indeed seriously incomplete. The implications of the suggested modifications for portfolio choice go in different directions, however. Taking a longer time perspective, accounting for the possibility that the household may not be moving, suggests that owning your home may be less risky than indicated by the static model, whereas adding income risk to the model suggests it is more risky. The general conclusion therefore remains

8 unaltered: allowing households to trade in index instruments has a strong potential to improve risk-return trade-offs.

5. Completing the markets in practice There is apparently a lack of well functioning markets that allow households and investors to adjust their positions in the housing market. Despite the rapid developments in recent years, financial markets remain incomplete in this important sense. From the discussion above we conclude that introducing such markets may not be of major importance for all, but should offer welfare improving opportunities for many households. Specifically (i) current homeowners with a high probability of moving in the near future would like to short their current housing market of residence and go long their market of destination; (ii) current renters who are contemplating owning in the future would like to be long their market of destination; (iii) investors in general – current renters in particular – would like to add some housing market exposure to their investment portfolio.

Over the last couple of decades economists have made a number of different proposals to create new markets and institutions that would allow households to alter their housing market exposure. Some of these are institutional arrangements or insurance products directed primarily at satisfying the hedging needs of current homeowners, category (i) above, whereas others are traded financial instruments that should be equally useful for anybody wanting to take a positive or negative position in the housing market. It is convenient to discuss these proposals under three separate headings: (a) new institutional arrangements for home ownership; (b) traded derivative instruments; (c) non-traded insurance and mortgage products.

5a New forms of homeownership From one perspective the basic problem is the indivisibility of housing units. Today, households face the all or nothing choice between owning an entire dwelling and not owning any housing at all, whereas optimal risk sharing would suggest owning just a fraction and having outside investors own the remainder. Making this possible is the basic idea behind the proposal of housing partnerships as launched by Caplin et al. (1997), and indeed behind the wide array of traditional shared equity arrangements discussed by Whitehead and Yates in this volume The resident household would naturally be the managing partner and have the full right to take day-to-day decisions and also decide on when to sell. Other details – e.g.

9 regarding decisions about major investments and sales procedures – would have to be specified in a contract between the parties.

In principle, the partnership idea is a perfect solution to the homeowner’s problem, as it allows offloading any fraction of the risks associated with a particular dwelling, not just those related to house prices in general. The problem is to ascertain that incentives for maintenance and sales effort are well aligned between the partners. To mitigate moral hazard problems – e.g. that the managing partner neglects maintenance – there is need for a relatively detailed contract between the partners. Even so, any contract would necessarily be incomplete and there would remain elements of the agency problems that make renting a cost-ineffective mode of consuming housing services (Henderson and Ioannides, 1983). Nevertheless, this is quite an interesting proposal as it addresses the central problem of homeownership head on. But since it may require new legislation, and in any case is likely to take long to get consumer acceptance, it is not of major importance in the foreseeable future.

5b Traded index derivatives The idea of setting up markets for index derivatives, see e.g. Case, Shiller and Weiss (1993) and Shiller (1998), is a very natural one. The exact form of the derivative – whether it be futures, options, swaps or some other contract – may not be so important. The general idea is simply to introduce an asset that would allow households and investors to change their exposure to housing market risk without altering the amount of direct ownership. It may be most straightforward to think in terms of a futures contract. A future is an agreement made today to exchange a certain item – e.g. a number of shares or a quantity of pork bellies – at a certain future date at a price that is fixed today. In practice, there is rarely any exchange of shares or pork bellies at the settlement date. Instead the deal is settled in cash, i.e. by a transfer of the difference between the agreed-upon futures price and the settlement price (the market price of the underlying asset at the settlement date). Most futures contracts are related to underlying traded assets, where direct physical settlement would be possible, but there is nothing in principle preventing trade in futures contracts where physical delivery is not possible, such as a property price index.

The first example, to my knowledge, of an exchange traded market for property price index futures was the London Fox market in the early 1990s. These futures were based on the Nationwide HPI. Unfortunately, the market was closed already after a few months of low

10 trading activity. Patel (1994) ascribes this failure to the announcement of fictitious trading prices in an attempt to give an inflated impression of market activity, though as Smith (2009) points out the failure was somewhat more complex than this implies. More recently, in 2005, the Chicago Mercantile Exchange (CME) started trade in futures and options based on Case- Shiller house price indexes for ten metropolitan areas in the U.S as well as a composite of them all. Recently, indexes for another ten metropolitan regions have been added. So far, trade has been limited in quantity, but active enough to generate daily price quotations. Labuszewski (2006) and the financial panel discussion in this volume give more details on the development of this market.

While the CME futures and options may be the only example of exchange traded housing index derivatives, there has recently been an increasing activity in over-the-counter (OTC ) trading related to commercial price indexes, primarily in swaps. The most active market is in swaps between LIBOR and total returns on the UK IPD index. The notional value of all contracts currently outstanding is around GBP 8 bn. While this is only one or two percent of the total value of all in the UK, it is still enough to maintain a liquid market. There is also a somewhat less active swap market in the UK Halifax residential index. The relative success of these markets has generated a considerable interest from the financial industry, and it appears that new markets are now starting to develop in many countries.4

5c Insurance products The development of new index derivatives markets discussed in the previous section is very exciting. It is not likely, however, that traded derivatives will attract much attention from the average homeowner (though see Smith, this volume). Derivatives contracts may seem difficult to understand, and many individuals may perceive them as risky, even if they actually serve to mitigate risk. Further, the contracts that are traded today (e.g. at CME) are for large metropolitan areas with limited relevance for the individual homeowner. Neither the inhabitants of Bronx nor of Nassau County may find the New York metropolitan area index suitable for hedging. Insurance type contracts should be more familiar and easier to understand for most homeowners. Furthermore, such contracts could be linked to more local price indexes or perhaps even to the transaction price of an individual property.

4 See, e.g., Risk and Manage. The Newsletter of the Property Derivative Market (www.tfsbrokers.com/pdf/RISK&MANAGE/2007/Oct-07.pdf).

11 The individual homeowner would ideally like to sign an insurance contract against fluctuations in the value of his own house. For obvious reasons, as discussed above, such contracts would meet with serious problems of moral hazard and adverse selection. They have only been offered under very special conditions. To name one example, a Swedish broker, Ragnar Bjurfors AB, was for some time in the early 2000s offering a guarantee to cover any loss in connection with the sale of a house. The guarantee, however, was conditional on the sale being forced by outside shocks like a divorce or the death of a spouse. It was offered in a generally booming market and was in all likelihood used in very few cases.

Another example of a product directly tied to the value of an individual property is the shared appreciation mortgage, offered by the Royal Bank of Scotland in the mid 1990s. This is a where the lender agrees to an interest rate lower than the prevailing market rate in exchange for a share of the appreciated value of the collateral property (settled at sale). Offered in a booming market, shared appreciation mortgages were not ex post beneficial to the borrowers and are not commonly available today.

In general it seems that products directly related to the price of an individual house will be too expensive, or surrounded with too many special clauses, to be broadly attractive. Products related to an index are likely to have more potential. A well publicized example of such a scheme is a federally supported pilot project, called Home Equity Protection, started in Syracuse, NY, in 2004; see Caplin et al. (2003) for a detailed description. Home Equity Protection offers insurance against losses in market value from the date of house purchase to sale, based on a zip code specific house price index. Insurance can be bought for an arbitrary base value up to the purchase price of the house, i.e. the payment at the time of sale is equal to the base value times the percentage index decrease during the holding period (or zero in case of a price increase). Despite the careful design of this project, and the local indexes that it is based on, it has not been a great success, perhaps because it was introduced in a booming market, when households did not assign much probability to falling house prices.

6. The Future The idea that index derivatives are useful devices for hedging residential house price risks has been put forward by economists for a couple of decades. So far, however, one cannot point to a single example of a successful launching of such instruments, neither as traded derivatives

12 nor as insurance products directly geared at households. Recent market developments – in particular in swap contracts for commercial price indexes, but also the CME market in house price derivatives – suggest that the time may now ripe for housing derivatives to succeed. So it is worth asking what problems have to be overcome in order to make house price insurance more widely available.

A key issue is whether households are really interested. Products offered have to meet specific household needs. In principle, it would seem preferable with contracts that disentangle house price risks from other risks like interest risks. In practice, however, it may be easier to sell combined products, like index-linked mortgages for those who want to go short and index- linked savings accounts for those who want be long in a housing market. Marketing is also important. There are two natural channels: real estate agents and mortgage lenders. Perhaps real estate agents may appear more neutral and could have larger credibility (at least today, in the aftermath of the subprime mortgage crisis). For long contracts connected with savings accounts, banks would appear to be the natural marketing channel.

Derivatives markets for professional actors and insurance contracts geared at individual households should not be seen as competing solutions, but rather as complements. Financial institutions offering home price insurance would need to hedge their risks. For a reasonably balanced portfolio of contracts across submarkets, metropolitan wide futures or options markets should offer good hedges. But in the absence of well functioning and liquid derivatives markets insurance prices would have to include hefty risk premia, making them less attractive to households.

Household interest would also depend on the relevance of the index. Traded derivatives are naturally limited to rather few indexes covering large markets. Insurance products could be tailored to much smaller areas, making them more attractive to individual households. But relevance also depends on the quality of the index. This is related to the quality of the underlying data. In many European countries, there is detailed public information about house characteristics, making it possible to estimate good hedonic indexes. In the U.S., on the other hand, only sales prices are available, making repeat-sales indexes the only viable alternative. It is also desirable to maintain arms-length distance between the insurance provider and the index producer. Ideally, the index should be produced by a government statistical agency. For all these reasons, the preconditions for hedging markets are generally better in Europe. Even

13 so, there is an unavoidable conflict between index relevance and statistical precision. A broad index can be based on many sales and hence be estimated with high precision but has limited economic relevance. The narrower the index area is the fewer are the number of sales and the more sensitive is the index to idiosyncratic variations in sales prices. The key question is whether it is possible to strike a balance between the Scylla of a metropolitan or nationwide index estimated with high precision and the Charybdis of a neighbourhood index excessively sensitive to individual transactions.

14 Figure 1. Index of relative price of a residential house in Greater London versus Scotland, 1983= 100 (Source: Halifax index)

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60 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005

15 Figure 2. Efficient frontiers for homeowner with house value/ net wealth = 4 (Source: Englund et al., 2002) Efficient Frontiers For Renter with 40 quarter horizon 0.2

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0.04

0.02 No Short & No Index Short & Index 0 0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6 1.8 Risk: Standard Deviation

Figure 3. Efficient frontiers for renter (Source: Englund et al., 2002) Efficient Frontiers For Poor Homeowner with 40 quarter horizon 0.2

0.18

0.16

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0.08 Expected Return 0.06

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0.02 No Short & No Index Short & Index 0 0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6 1.8 Risk: Standard Deviation

16 References

Caplin, A., S. Chan, C. Freeman, and J. Tracy (1997), Housing Partnerships: A New Approach to a Market at a Crossroads, MIT Press. Caplin, A., W. Goetzmann, E. Hangen, B. Nalebuff, E. Prentice, J. Rodkin, M. Spiegel and T. Skinner (2003), “Home Equity Insurance: A Pilot Project”, Yale International Center for Finance, Yale ICF Working Paper 03-12. Case, K. E., R. J. Shiller, and A. N. Weiss (1993), “Index-Based Futures and Options Markets in Real Estate”, Journal of Portfolio Management, 19, 83-92. Davidoff, T. (2006), “Labor Income, Housing Prices and Homeownership”, Journal of Urban Economics 59, 209-235 Englund, P. Hwang, M, and Quigley,J (2002), “Hedging Housing Risk”, Journal Real Estate Finance and Economics 24, 167-200. Englund, P., J.M. Quigley and C. Redfearn (1998), ”Improved Price Indexes for Real Estate: Measuring the Course of Swedish Housing Prices”, Journal of Urban Economics 44, 171-196. Flavin, M. and T. Yamashita (2002), ”Owner-Occupied Housing and the Composition of the Household Portfolio”, American Economic Review 92, 345-362. Goetzmann, W. N. (1993), "The Single Family Home in the Investment Portfolio," Journal of Real Estate Finance and Economics 6, 201-222. Henderson, J.V. and Y.M. Ioannides (1983), “A Model of Housing Tenure Choice” American Economic Review 73, 98-113 Hilber, C. (2007), "The Determinants of Homeownership across Europe: Panel Data Evidence", manuscript, London School of Economics. Iacoviello, M. and F. Ortalo-Magné (2003), ”Hedging Housing Risk in London”, Journal of Real Estate Finance and Economics 27, 191-209. le Blanc, D. and C. Lagarenne (2004), “Owner-Occupied Housing and the Composition of the Household Portfolio: The Case of France”, Journal of Real Estate Finance and Economics 29, 259-275. Jansson, T. (2008), “Portfolio Implications of Unemployment Risk and Uncertain Housing Prices”, manuscript, Stockholm School of Economics. Labuszewski (2006) Patel, K. (1994), ”Lessons From the FOX Residential Property Futures and Mortgage Interest Futures Market”, Housing Policy Debate 5, 343-360. Shiller, R.J. (1998), Macro Markets. Creating Institutions for Managing Society’s Largest Economic Risks, Oxford University Press. Sinai, T. and N. Souleles (2005), ”Owner-Occupied Housing as a Hedge Against Rent Risk.” Quarterly Journal of Economics 120, 763-789. Smith, S. (2009), Voicu, C. (2007), “Optimal Portfolios with Housing Derivatives”, manuscript, Harvard Business School.

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