Household Decisions when Stocks, Labor Income and House Prices Share a Common Trend

Project Start:07/2014
Status:Completed
Researchers:Holger Kraft
Category: Household Finance
Funded by:LOEWE

In this project, we study the relation between stock prices, house prices, and labor income. According to earlier studies, we expect that the drift rates are correlated with shocks to stock prices, house prices, and income so that these quantities tend to move together in the long run in spite of low contemporaneous correlations. Incorporating these long-run relations into a life-cycle household optimization problem should affect the optimal consumption, housing, and investment decisions significantly.

At first, we will do an empirical analysis. We will estimate the joint dynamics of stock prices, house prices and labor income. Following Campbell and Viceira (1999), we use the dividend price ratio to predict stock returns. To predict house returns and labor income returns, we use GDP growth. We plan to estimate a five dimensional VAR(1) to calibrate jointly the dynamics of stock return, house returns, labor income, dividend-price ratio and GDP growth.

Based on these results, we will embed the estimated long-run dynamic model into a continuous-time, life-cycle utility maximization problem of an individual (or household). The individual has time-additive Cobb-Douglas power utility over the consumption of perishable goods and of housing services. The individual earns a labor income stream with an age- dependent drift until retirement, after which a pension equal to a fraction of pre-retirement income is received. Labor income entails risks that cannot be hedged through investments. Savings can be invested in a risk-free asset, a stock index, and in housing units. Housing units can be rented or purchased (and resold) and, hence, the individual can disentangle housing consumption from housing investments. We impose standard short-selling and borrowing constraints.

We have completed the empirical analysis. We have estimated the joint dynamics of stock prices, house prices and labor income.

Based on these results, we derived a model with a long-run relation between stock prices, house prices and labor income. We solved this continuous-time, life-cycle utility maximization problem of an individual and modified our solution method. Currently, we are studying the results.

 

Related Published Papers

Author/sTitleYearProgram AreaKeywords
Holger Kraft, Claus Munk, Farina WeissPredictors and Portfolios Over the Life Cycle
Journal of Banking and Finance
2019 Household Finance Return predictability, human capital, housing, investments, welfare

Related Working Papers

No.Author/sTitleYearProgram AreaKeywords
139Holger Kraft, Claus Munk, Farina WeissPredictors and Portfolios Over the Life Cycle2016 Household Finance Return predictability, human capital, housing, investments, welfare
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