A Theory of Housing Collateral, Consumption Insurance and Risk Premia

Abstract

In a model with housing collateral, the ratio of housing wealth to total wealth shifts the conditional distribution of asset prices and consumption growth. A decrease in house prices reduces the collateral value of housing, increases household exposure to idiosyncratic risk, and increases the conditional market price of risk. The model quantitatively accounts for conditional asset pricing moments, cross-sectional variation in value portfolio returns and key unconditional asset pricing moments. The increase of the equity premium and Sharpe ratio when collateral is scarce matches the increase observed in US data. The model also generates a return spread of value firms over growth firms of the magnitude observed in the data. Assets with payoffs that lay farther in the future are less risky. Growth stocks are such long duration assets.