Asset pricing and portfolio choice in the presence of housing

The portfolio decisions made by consumers have important implications for individual welfare and asset prices. This work addresses the frictions faced by consumers investing across asset classes and the implications those frictions have on asset prices. Specifically, I focus on the choice between housing and financial assets. Although there is a broad literature on returns to holding housing, standard structural models from the finance literature have largely been overlooked when pricing housing market returns. I argue in this line of work that by evaluating and pricing housing within the same frameworks in which equities and bonds are priced, we can better evaluate portfolio choices.;In addition to using financial economic theory to understand housing markets, we can use housing markets to gain a better understanding of other asset markets. Owner-occupied housing is unique in that it is traded in local markets, which are heterogeneous in their economic and demographic characteristics. This heterogeneity in the investor base is a source of variation from which to explore the link between asset prices and uncertainty in the expected future consumption flows of investors.;The first essay, "Pricing Housing Market Returns," finds the housing premium to be smaller than the equity premium. Using state-level data that spans the 1983 to 2006 period, I estimate the asset pricing Euler equations from the intertemporal consumption problem faced by a representative consumer with Epstein-Zin (EZ) preferences. EZ preferences allow the consumer to have a different level of aversion to variation in consumption across states of nature than to variation in consumption over time. The EZ Capital Asset Pricing Model captures a large proportion of the variation in housing returns over the sample period, and I find there to be heterogeneity in the structural parameter estimates across geographies. Controlling for the risk priced by the model and the consumption value of housing, I find that the housing premium is smaller than the equity premium. This result is surprising given that frictions, such as high transaction costs and borrowing constraints, affect the investor in housing more than the investor in equities. I examine institutional differences between the asset classes and find that some of the difference between the two premia may be related to differences in the tax treatment between the two asset classes.;The second essay, "Non-durable Consumption Volatility and Illiquid Assets," finds that factors beyond the volatility of asset payoffs may significantly affect the volatility of the agent's consumption stream. The empirical failure of consumption-based asset pricing models is often attributed to the lack of volatility in aggregate measures of consumption. However, I illustrate in this paper that frictions faced by agents may lead to much higher levels of volatility in individual consumption than we observe in the aggregate data. I identify five distinguishing characteristics of assets, and develop a life-cycle model of the consumer which incorporates these features. The consumer derives utility from non-durable consumption and stock in a risky asset: housing. A key feature of the model is that the housing adjustment costs are non-convex. These adjustment costs generate lumpy changes in the stock of the risky asset over the life-cycle. The model predicts that non-durable consumption volatility is increasing in both the ability to borrow against the assets held in the consumer's portfolio and in the illiquidity of the portfolio. Because the liquidity of the investor's portfolio may depend on the thinness of the housing market in which the investor resides, investors in different geographies may value the same asset differently.;The third essay, "Local and Global Risks in U.S. Housing Markets," finds that variation in the cross section of expected housing market returns is better explained by a local CAPM model than by a global CAPM model. Housing is unlike many other assets in that it is primarily traded in local markets. The 2000 U.S. Census indicates that over 66% of housing units are owner occupied. A housing return is the combination of a capital gain and a consumption flow. In the last 30 years in the United States, the consumption flow yield has accounted for approximately 69% of average real return to homeownership. Frictions that prevent owners from realizing the consumption flow, either directly or indirectly via renting the property, can significantly drive down the net real return received for owning the property. For mean-variance optimizing investors, relatively small investment costs (less than 3.5% annually) will prevent the investor from optimally investing in housing markets in which the investor doesn't reside. I propose two possible models for U.S. housing markets. The local CAPM assumes that only investors residing in the geographic region that constitutes market i invest in housing market i. The global CAPM assumes that investors who don't reside in the geographic region that constitutes market i have costless access to the assets in that market. I test the ability of these models to explain the cross section of expected real housing returns and find that smaller mean pricing errors are associated with the local model.