Risk Dynamics of Housing Market: Cross-sectional Variations, Time Variations and Economic Fluctuations

This paper estimates both the conditional systematic and idiosyncratic risks in the housing market using the monthly housing price data on U.S metropolitan areas over the sample period Jan 1987 to Oct 2008. Different to previous studies, this paper decomposes the total risk in housing market into both the systematic and the nonsystematic parts by introducing new model-independent approaches for the measure of aggregate systematic and idiosyncratic risks, the PCA approach, the portfolio approach as well as the cross-section dispersion approach which do not depend on any parametric specifications of the return generating process such as the CAPM model or three-factor capital asset pricing model. The time-series properties of conditional risks in the housing market are found to be time varying and highly persistent as following a random walk process. Furthermore, the housing risk fluctuations can be largely explained by macroeconomic variables such as the credit spread and the inflation rate. In addition, using the portfolio sorting methodology, this paper finds that the housing portfolio with high idiosyncratic volatility has high expected returns. The results offer the new evidences supporting Merton’s (1987) proposition that idiosyncratic volatility should be positively related to the cross-section of expected returns if investors demand compensation for imperfect diversification in presence of incomplete information. Keyword Risk Dynamics; Housing; Cross-sectional Returns; PCA; Portfolio; Time-Varying JEL Code G11; G12; G15